The average directional index (ADX) is an indicator used in technical analysis as an objective value for the strength of a trend. ADX is non-directional, so it quantifies a trend's strength regardless of whether it is up or down. It is usually plotted in a chart window along with two lines known as the DMI (Directional Movement Indicators).
There are two forms of stock analysis: fundamental and technical. Fundamental analysis selects stocks based on business performance, whereas technical analysis selects stocks based on price movement. When technicians look for patterns over time to confirm a continuation or trend reversal, they often use the average directional index as an indicator. Developed by Welles Wilder for use with commodities and daily prices, the indicator is also used for stock selection. Wilder used the plus directional movement (+DM) and the minus direction movement (-DM) to determine the ADX.
Traders believe that the trend is your friend. As a result, there are numerous trading indicators that are meant to confirm a trend. Once the trend is identified, however, the challenge is determining the best time to enter and exit a trade. The ADX is used to measure the strength or weakness of a trend and is therefore used alongside the +DM and -DM to determine the best course of action. Put together, Wilder created a framework for trading out of the ADX, DI+ and DI- trio of lines.
Traders start by using the ADX to determine if there is a trend. A strong trend is occurring when the ADX is over 25; likewise, there is no trend when the ADX falls below 20. When the +DI line is greater than the -DI line, the bulls have the directional edge. However, when the -DI line is above the +DI line, the bears have the directional edge. As with all technical trends, traders use several indicators to confirm a movement. One option is to sell when -DI is up and the major trend is down. Another option is to buy when +DI is higher than -DI, but only when the larger trend is also moving up. In other words, it is possible to use the ADX as a way to time an entry on a market that is already confirmed to be trading in a particular direction.