Entry The directional movement system is a trend following system that being so the entry signal should only be taken at the earliest indication of a trend emerging or in effect. Consequently the ADX should be pointed up at all times when entry is being considered. Welles Wilder's criteria were ADX up and at 25 or better (he recognized the dilemma of the grey area ADX up but >20 but < 25). Wilder later suggested the three consecutive up readings with the ADX at 20 or better as an acceptable criterion. My studies suggest a high probability of success if one has three consecutive up reading of the ADX above 15, after all trends emerge from non trends.
Exit
The turning points in markets are often heralded by turns in the DI+/DI- at upper and lower extremes shortly followed by a down turn in the ADX which is above both DI lines. This sign is near coincident with major turning points, usually a very short time lag. So this reversal of the ADX at these lofty levels is a good place to take profits and STAND ASIDE.
Entry Protective Stop
Welles Wilder recommended that the price bar of the period that the DI+/DI- crossovers occur (day bar if day chart, that hourly bar if an hourly chart) the extreme low of the price bar is the stop if you are going long and the extreme high is the stop if you are going short, and to hold your position regardless if there are a few subsequent DI+/DI- crossovers shortly afterwards. If stopped out a reverse should be strongly considered. This works well on daily charts but on intra day charts it is very frequently tagged by the floor traders before reversing and trending in the direction you had traded. This frustration may be overcome by adding 2 or 3 ticks to the indicated stop or taking the extreme high (or low) of the preceding price bar. I have found the latter to be the more reliable, if that is violated it is usually a sign to reverse the trade.
Confirmation of the trade and adding positions
a) Trading the New Trend. After taking the initiating DI+/DI- crossover with an appropriately scored, upward moving ADX from levels below 15 the ADX will track up and cross above the falling DI line () on this ADX/DI crossover the trend is very frequently confirmed and is a good place to add a position. Or if you failed to take the original DI crossover entry signal, then this is a good position to enter. One caveat sometimes the market at this time is short term over bought or over sold, if it is, wait for the likely retracement and consolidation then enter.
b)Trading at the end of a Trend. If, whatever reason you decided to trade a trend termination and possible reversal, you will have entered on the DI+/DI- crossover in high territory with ADX also in high, in fact higher territory, and having turned down. When the now declining ADX crosses below the falling lower DI line then this is a place to add to your counter trend trade.
Using the ADX to trade with other Technical Indicators
The ADX gives important information on the market environment. Without being acutely attuned to the market environment you are doomed to fail. The ADX gives you market environment information par excellence. The ADX tells you if there is a trend present or not. It also informs you if it is early or late in a trend. The end of the most recent thrust of the trend is heralded by the ADX. It informs of a de-trending (correcting market), of reversal and renewal. Wilder calculated that markets trend for 30% or less of the time and were non-trending or range bound for the other 70% of the time. Trend following indicators are lethal in non-trending markets and oscillators suitable to non-trending markets are murderous if used in trending markets. So with reference to the ADX you can readily determine which of the two main types of indicators you should be using in the current market environment. The table indicates the appropriate type of indicator for different ADX defined market environments.
ADX Score| ADX Direction| Appropriate Tech.| Indicator to Use0 - 15 Up or Down Range - Use Oscillators
16 - 20* Up Trend - Use Trend Following Indicators
21 - 40 Up Trend - Use Trend Following Indicators
> 40** Up Be Prepared For Trend To End
> 40 - 25 Down De-trending - Use Oscillators
24 - 0 Down Non-trending - Use Oscillators - J.Welles Wilder originally suggested ADX of 25 or higher to indicat presence of trend. This is often late in confirming trend entry. Trends emerge from non-trends. I have found it appropriate if, in the range 16 - 20(25), you have three consecutive up moves in the ADX prior to a DI entry crossover, then the DI entry can be taken with a high degree of success.
- The turn down of the ADX at these levels, when it above both DI lines, almost always means the end of that trend. It does not necessarily mean trend reversal, more likely a period of retracement and consolidation. Time to exit. Stand aside. Reverse only on other evidence of trend reversal.