One of the key pieces of information for a trader is whether or not an instrument is trending. If trending, then trend following techniques are appropriate, for example, buying uptrends on dips or selling down trends on rallies, channel or volatility break outs, or moving average crossover techniques. If not trending, then other techniques come in to play, for example buying support or oscillator weakness, and selling resistance or oscillator strength.

A number of tools have been designed to help identify and measure trends, and the Average Directional Index and related indicators created by Welles Wilder are amongst the most robust of these tools. The key concept underlying the Average Directional Index is that in an uptrend more of today's trading range will be above yesterday's high than will be below yesterday's low, vice versa in a downtrend. (Note, this tool is most commonly used on daily charts, but can be used for any time period, for example weekly, or intra day).

There are three components to this tool. +DI is a directional indicator which measures how much on average over a look back period each day's trading range has been above the high of the previous day, expressed as a percentage of the day's range. -DI measures in similar fashion how much  on average each day's trading range has been below the low of the previous day. ADX (Average Directional Index) measures the difference between +DI and -DI, so when the two directional indicators are moving apart ADX will increase. The standard look back period is 14 days (per Welles Wilder) however other settings are often used, for instance 8, 13 and 18. As with all indicators, there is generally a trade off between speed and accuracy of signals, the lower settings will give you quicker signals, but there may be more false signals.

The +DI effectively measures the strength of the bulls, the -DI the strength of the bears. Whichever of these two indicators is above the other, that is the dominant one; in an uptrend DI+ will be higher than DI-, in a downtrend DI- will be higher than DI+.

The ADX measures the strength (or otherwise) of the trend. If the ADX is above 25 this is taken as an indication that a trend is in place, and trend following techniques can be used. (Some traders use 30 as their cut off.) A rising ADX means the trend is increasing in strength, a falling ADX signifies either consolidation or a potential reversal of trend.

One note of caution, ADX usually lags price action a little, and by a significant amount in a sharp trend reversal. No indicator is perfect.

So what trading strategies can be used with this tool? In essence, the tool can be used both as a filter to identify when and when not to use trend following techniques; in addition the tool is also used by some traders to generate entry or exit signals.

Here are some examples of various assumptions traders make using this tool to give themselves an edge:

1. If ADX is above 25 and rising and +DI is above DI, this is a strong uptrend, look to buy on a pullback
2. If ADX is above 25 and rising and -DI is above +DI, this is a strong downtrend, look to sell on a rally
3. If ADX is less than 25, this not a strong trend, do not use trend following techniques
4. If  +DI and -DI are moving sideways and less than 25, and ADX is less than 25, there is no trend, do not use trend following techniques
5. If ADX moves above both +DI and -DI and then turns down, this is a warning sign, the trend may be weakening
6. If +DI crosses up over -DI  this is potentially a new uptrend, buy a break of the high of the crossover day
7. If -DI crosses up over +DI this is potentially a new downtrend, sell a break of the low of the crossover day