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The average directional index is a tool used by traders to determine the strength of investment trends. It appears on a chart with two other lines: the negative directional indicator and the positive directional indicator. Together, these lines are known as directional movement indicators (DMI). The relationship between these two indicators can help a trader to determine the average directional index. Over time, a pattern will develop in the index, which can help an investor to pick the best possible time to exit an investment.
In general, an average directional index can show an investor if a trend is gathering steam or beginning to fade. The index gauges the overall strength of a trend regardless of its market position. This gives the trader the opportunity to sell an asset before it drops and becomes a liability.
A typical average directional index will be plotted on a chart with both the positive and negative directional indicators. The indicators are plotted as two lines with different colors running horizontally across the top. The relationship between these lines is used to calculate the index, which typically appears as a single black line at the bottom of the chart.
One of the advantages of the average directional index is that over time it can reveal more about the nature of a trend and its relationship with the market. If the trend’s strength rises and diminishes with the market, then it is possible that its fluctuations are not specifically related to the trend. When a trend appears to be moving in patterns separate from the market, then it is more likely that the movement is a reaction to that trend.
An average directional index can also establish a pattern which may enable an investor to determine the peak time to sell. For example, a trend may have a fairly regular occurrence of dips and peaks. Upon observing this pattern, the investor can forecast when the trend will peak again, and plan to sell at that point. While there is still some risk involved, it is more likely that the investor will pick the most beneficial time to make a move.
The American mechanical engineer J. Welles Wilder, Jr., created the average directional index in 1978. It was one of several technical indicators he created during his long technical analysis career. Many of Wilder’s innovations became elements in technical analysis software that was developed in later years.
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