Although Wilder designed his Directional Movement System with commodities and daily prices in mind, these indicators can also be applied to stocks. Positive and negative directional movement form the backbone of the Directional Movement System.
Wilder determined directional movement by comparing the difference between two consecutive lows with the difference between their respective highs. Using these three indicators together, chartists can determine both the direction and strength of the trend. Despite being developed before the computer age, Wilder's indicators are incredibly detailed in their calculation and have stood the test of time.
Directional movement is calculated by comparing the difference between two consecutive lows with the difference between their respective highs. Directional movement is positive plus when the current high minus the prior high is greater than the prior low minus the current low. A negative value would simply be entered as zero. Directional movement is negative minus when the prior low minus the current low is greater than the current high minus the prior high.
This so-called Minus Directional Movement -DM equals the prior low minus the current low, provided it is positive. The chart above shows four calculation examples for directional movement. The third pairing shows a big difference between the lows for a strong Minus Directional Movement -DM. The final pairing shows an inside day, which amounts to no directional movement zero. All inside days will have zero directional movement. Basically, ATR is Wilder's version of the two-period trading range.
The calculation example below is based on a period indicator setting, as recommended by Wilder. Above is a spreadsheet example with all the calculations involved. There is a day calculation gap because approximately periods are required to absorb the smoothing techniques. Because of Wilder's smoothing techniques, it can take around periods of data to get true ADX values.
ADX values using only 30 periods of historical data will not match ADX values using periods of historical data. ADX values with days or more of data will remain consistent. As with an exponential moving average , the calculation has to start somewhere so the first value is simply the sum of the first 14 periods.
As shown below, smoothing starts with the second period calculation and continues throughout. First, calculate an average for the first 14 days as a starting point. The second and subsequent calculations use the smoothing technique below:. Crosses of these directional indicators can be combined with ADX for a complete trading system. Before looking at some signals with examples, keep in mind that Wilder was a commodity and currency trader.
The examples in his books are based on these instruments, not stocks. This does not mean his indicators cannot be used with stocks. Some stocks have price characteristics similar to commodities, which tend to be more volatile with short and strong trends.
Stocks with low volatility may not generate signals based on Wilder's parameters. Chartists will likely need to adjust the indicator settings or the signal parameters according to the characteristics of the security.
This determination helps traders choose between a trend-following system or a non-trend-following system. Wilder suggests that a strong trend is present when ADX is above 25 and no trend is present when below There appears to be a gray zone between 20 and As noted above, chartists may need to adjust the settings to increase sensitivity and signals.
ADX also has a fair amount of lag because of all the smoothing techniques. Many technical analysts use 20 as the key level for ADX. The stock moved from a strong uptrend to a strong downtrend in April-May, but ADX remained above 20 because the strong uptrend quickly changed into a strong downtrend.
There were two non-trending periods as the stock formed a bottom in February and August. A strong trend emerged after the August bottom as ADX moved above 20 and remained above Wilder put forth a simple system for trading with these directional movement indicators. The first requirement is for ADX to be trading above This ensures that prices are trending.
Many traders, however, use 20 as the key level. Wilder based the initial stop on the low of the signal day. Wait for this low to be penetrated before abandoning the signal. Once the trend develops and becomes profitable, traders will have to incorporate a stop-loss and trailing stop should the trend continue.
The high on the day of the sell signal becomes the initial stop-loss. The chart above shows Medco Health Solutions with the three directional movement indicators. Note that 20 is used instead of 25 to qualify ADX signals.
A lower setting means more possible signals. The green dotted lines show the buy signals and the red dotted lines show the sell signals. Wilder's initial stops were not incorporated in order to focus on the indicator signals. Some occur with ADX above 20 to validate signals. Others occur to invalidate signals. As with most such systems, there will be whipsaws, great signals, and bad signals. The key, as always, is to incorporate other aspects of technical analysis. For example, the first group of whipsaws in September occurred during a consolidation.
Moreover, this consolidation looked like a flag, which is a bullish consolidation that forms after an advance. It would have been prudent to ignore bearish signals with a bullish continuation pattern taking shape. It would have been prudent to ignore a buy signal so close to this resistance zone. These three signals were pretty good, provided profits were taken and trailing stops were used. Wilder's Parabolic SAR could have been used to set a trailing stop-loss.
Notice that there was no sell signal between the March and July buy signals. The Directional Movement System indicator calculations are complex, interpretation is straightforward, and successful implementation takes practice. Setting an ADX requirement will reduce signals, but this uber-smoothed indicator tends to filter as many good signals as bad.
These crossover signals will be similar to those generated using momentum oscillators. Therefore, chartists need to look elsewhere for confirmation help. Volume-based indicators, basic trend analysis, and chart patterns can help distinguish strong crossover signals from weak crossover signals.
SharpCharts users can plot these three directional movement indicators by selecting Average Directional Index ADX from the indicator dropdown list.
This makes it easy to identify directional indicator crosses. While ADX can be plotted above, below or behind the main price plot, it is recommended to plot above or below because there are three lines involved.
A horizontal line can be added to help identify ADX moves. The moving average is used to filter signals. Only buy signals are used when trading above the day moving average. Once initiated, the Parabolic SAR can be used to set stops. Click here for a live example of ADX.
This scan starts with stocks that average , shares daily volume and have an average closing price above An uptrend is present when trading above the day SMA. A buy signal is possible when ADX is above A downtrend is present when trading below the day SMA. A sell signal is possible when ADX is above Log In Sign Up Help. Smooth these periodic values using Wilder's smoothing techniques. These are explained in detail in the next section. Multiply by to move the decimal point two places.
Multiply the result by to move the decimal point over two places. The second and subsequent calculations use the smoothing technique below:More...