When I started testing and developing trading systems two decades ago, I didn’t approach it as the typical data-mining Quant, but instead as a trading practitioner. I was already a chartist and focused on directional price trends. I just wanted to quantify the edge.
Quantifying an edge requires testing the entry/exit/size system to determine its mathematical expectation. Are the average profits > average losses? ie. Does it generate asymmetric investment returns? You can probably see why I trademarked it.
Instead of reinventing the wheel and going on a data mining fishing expedition, I focused on publicly known indicators, and my favorites were developed in 1978 by J. Welles Wilder. Average Directional Movement (ADX) was one, and it measures a trend’s strength and direction.
The Average Directional Index (ADX), Minus Directional Indicator (-DI) and Plus Directional Indicator (+DI) These three factors combined indicate the direction and strength of the trend.
The foundation of the Directional Movement System is positive and negative directional movement. Wilder’s ADX calculates the direction of movement by comparing the distance between two consecutive lows to the distance between each low’s corresponding high.
Directional movement is + when the current high – the prior high is greater than the prior low – the current low. +DMI = the current high – the prior high (if it’s +). -DMI is – when the prior low – the current low is > than the current high – the prior high +DMI is green:
+DMI is green for positive directional movement. -DMI is red for negative directional movement. ADX measures the strength/weakness of a trend, not its direction.
All that to get to an interpretation of today’s S&P 500. Uptrending green is showing positive directional movement, but just as important, it’s coming from a very low ADX. Buying pressure is dominant when +DM > -DM Low ADX signals recent weakness, with room to strengthen.
No indicator is perfect, and neither is ADX/DMI. It’s just a mathematical way to quantify trend direction and strength.
It’s a reminder to me that if this is a new uptrend, it’s from a lower (risk) starting point with much room to run if it will…
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