A friend of mine forwarded me a very nice and a practical write up on the ADX by Ty Young. I have reproduced below certain points he has discussed in the article. For a detailed study along with chart examples and a short video on the same can be viewed here. Additional reading on the ADX can be done at Investopedia and at Stockcharts.
J. Welles Wilder developed the Average Directional Index (ADX) to evaluate the strength of a current trend, be it up or down. It's important to determine whether the market is trending or trading (moving sideways), because certain indicators give more useful results depending on the market doing one or the other. The ADX is derived from two other indicators, also developed by Wilder, called the Positive Directional Indicator (sometimes written +DI) and the Negative Directional Indicator (-DI).
• The DI’s and the ADX are displayed on a scale which has a range of 0 – 100.
• When the +DI is above the -DI, a bullish market is implied. It’s vice versa in case of –DI being above the +DI.
• True Directional Movement is the Difference between the +DI (14) and the – DI (14). “The more directional the movement of an index, the greater will be the difference between the DI’s”; in other words, after the DI’s cross and their difference increases they begin to “pull away” from each other (the gap widens), while subsequently, the ADX continues to rise – implying a “trending” market.
• If the price is criss-crossing in a sideways direction, then the gap would be narrowing – implying a “non-trending” market.
• In essence, the ADX is smoothing the action calculated by the DI’s.
The ADX just shows us the strength of the market; it doesn’t tell us the direction of the market. For direction we see the +DI and the –DI. Though merely crossing of the DI’s shouldn’t be taken as an absolute signal, it should be treated as an early warning signal and subjected to the guidelines below:
• If the ADX reading is below 20 or the ADX drops below both DI’s - a “weak trend” or a “non-trending” market is implied. Therefore a “non-trending” system should be used for confirmation, i.e., oscillators, such as MACD or Stochastics.
• When the ADX drops below 10, the current trend is virtually dead. Be ready for the beginning of a new trend – bullish or bearish; the ADX doesn’t distinguish the direction. Use your other indicators to make this decision. However, after a period of consolidation, a “new” trend may resume in the previous direction.
• An ADX reading above 20 implies the “beginning” of a new trend; whereas; a rise above 25 implies a “trending” market.
• IF the ADX rises above the 40 level, the market is even stronger; however…
• If the ADX subsequently drops below the 40 level, it’s an early indication that the market is weakening, which frequently leads to a reversal.
• Subsequently, a turndown at the lower levels (without reaching the 40 line) is generally a retracement or consolidation signal (not a reversal signal). Look for confirmation and trade accordingly.
• After the DI’s cross and their difference increases; in other words, as they begin to “pull away” from each other; better yet, the gap widens, while subsequently, the ADX continues to rise – trending market strength is implied.
• Once the ADX breaks above the +DI and the –DI, a retracement or reversal is on the horizon.
As is it with all the indicators here also the same warning goes that one must always look for conformation from the PRICE!