Today, we will take a look at Directional Movement Index (DMI), the basic principle and the practical application in charting analysis.
I had been using DMI as part of my technical indicators along side MASCD, ADX, RSI, and ATR etc.
The Directional Movement Index (popular known as DMI) is a momentum indicator that was invented by J. Welles Wilder. The DMI is actually part of a series of technical indicators developed by Wilder, so some trading platforms split up the indicators, providing Directional Movement as one indicator and ADX as another. Typically, these indicators are used together to form the DMI. Directional Movement signal whether downside or upside movement is stronger and ADX shows the strength of that movement.
The Average Directional Index (ADX) when coupled with the positive (+DMI) and the negative (-DMI) directional indicators, provide a complete and accurate trading system. It’s not possible to go into the full details of how to arrive at the indicators in this limited space, but it is possible to have a discussion about the concept.
Read on below to see how DMI could help us making trading decisions.
The Introduction of Directional Movement Index
It is computed by contrasting the present cost and the past value run. DMI at that point shows the outcome as an upward directional list (+DI) and a descending directional file (- DI). The DMI additionally ascertains the quality of the upward or descending movement and shows the outcome as a pattern quality line called Average Directional Index or ADX.
+DI and – DI appear as two separate lines, shaded green and red individually. At the point when the red line is over the green line, it implies the price is dropping. At the point when the green line is over the red line, it implies the price is rising.
If the -DI and +DI are criss-crossing back and forth, there likely isn’t a price trend going on, and the price is moving sideways.
ADX is a third line on the pointer, and it demonstrates the strength of the pattern.
So while the – DI and +DI help feature the price direction, ADX concentrates on how solid the uptrend or downtrend is. An ADX perusing over 25 signals a solid pattern is set up. At the point when the ADX is wavering underneath 25 it typically implies there isn’t a solid pattern, and the price is moving sideways or inside a powerless pattern.
The chart demonstrates a one-minute graph with ADX and Directional Movement lines (- DI and +DI). In the outline, the markers are isolated to maintain a strategic distance from the mess, however, it is conceivable (and normal) to have the ADX, – DI, and +DI all appeared in one window (rather than two). The markers can likewise be utilized independently, however. A few traders may just view the ADX for trend quality, while others may incline toward just review the Direction Movement lines to help in affirming price pattern.
Use Directional Movement Index In Trade Setup
The Directional Movement Index can be used in both ranging and trending markets. In general, when the +DI line is above the -DI line, the market is moving upwards, and when the -DI line is above the +DI line, the market is moving downwards. If trading a trending strategy, favor long positions when the +DI is above the -DI line, and try to avoid long trades when the -DI is above the +DI. When the -DI is above the +DI, favor short positions, and avoid taking short positions when the +DI is above the -DI.
The ADX line shows the strength of the price move. The market is considered to be trending when the ADX line is above 25, and ranging when the ADX line is below 25. Many trades also consider an ADX reading above 20 as trending, and below 20 as non-trending.
Used in conjunction with the Directional Movement uses discussed above, ADX can act to further filter or confirm trade signals. If trading a trending strategy, the ADX should ideally be above 20 (or 25) for taking trades in potential uptrends or downtrends. For trading strategies that trade ranges (sideways movement) then ADX should be below 20 (or 25).
The rules for using the Directional Movement Indicator are:
- You establish a long position whenever the Plus DI crosses above the Minus DI.
- You establish a short position, when the Minus DI crosses above the Plus DI.
A simple DI+/DI- crossover is an entry and exit system. However, used that way it produces frequent whipsaws.
Hence we combine this with the ADX to reduce these whipsaws.
The ADX is the integral part of this system, as it gives a warning for a market about to change direction. It gives precise interpretations of the price action as follows:
- It tells you if there is a trend present or not.
- It also informs you if it is early or late in a trend.
- It informs of a de-trending, of a reversal and renewal.
- If the ADX line is trading above 20, then the market is in a trend.
- If the ADX line is below 20, it means the trend is not a strong one.
- As long as the ADX line is above 20, you should still consider a trend to be in effect.
The ADX however does not indicate the direction of the trend, only the strength of the trend
Once we have these basics clear, let us add some filters to these indicators, which will enhance the characteristics.
Now in our chart here, we have the red line as the minus DI, the blue line as the plus DI, and the green line is the ADX. I have drawn a line at the 20 level for the ADX, since the rise of the ADX above 20 signifies an emerging of a trend.
Overall, if we observe only the two DMI lines (the blue and the red) it does give a correct picture of the trend, and keeps us in the correct side of the market.
Simply put, at the area marked with the red line, the –DMI line, is above the +DMI line, signifying a downtrend.
And at the area marked with the blue line, the +DMI line is above the –DMI line, signifying an uptrend.
But what about the areas, where the DMI lines have frequent crossings?
This is the kind of situation which will whipsaw out any position and this where the ADX is used in tandem. For these kinds of situations we define certain parameters, which will help us make a correct decision.
For the effective use of this indicator, the rules for a trade should be:
- The ADX must have 3 consecutive higher readings above 20 to confirm that we are entering into a trend.
- The ADX should be pointed up at all times when entry is being considered
- If at this time, the plus DMI (the blue line) is above the minus DMI (the red line), which indicates an uptrend, then the ADX should have also crossed the minus DMI (the red line). This is a very important confirming factor.
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 DMI crossover entry signal, then this is a good position to enter.
- We place our stops at the low of the bar, where the DMI lines have the crossover.
- We look to exit the trade only when the ADX line starts to fall down.
This use of the ADX for the exits is called the “turning-point” concept.
- First, the ADX must be above both DI lines.
- When the ADX turns lower, the market often reverses the current trend.
- 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. So the reversal of the ADX at these high levels is a good place to take profits and STAND ASIDE.
These rules will help keep us out of a whipsaw trade, give us a safe stop point, and a proper exit to protect our profits.
If we apply our rules to our example here:
We will consider an entry only at this point marked ‘A’, when the ADX has had 3 higher readings.
At this point the ADX has already crossed the minus DMI line, so we have an added confirmation to the trade.
We have our stop level clearly defined, and we place it beneath the low of the bar where the DMI lines have crossed.
We consider exiting the trade, only when the plus DMI has reached an extreme level, and the ADX is turning down at this point.
This keeps us in the trade till the end of the trend.
If you notice at the area marked with red dot, the price had a retracement to the downside. But since the ADX was still rising, the -DMI had not crossed above the +DMI line, and the +DMI had not yet reached the overbought level, we could decide to stay with the trend.
And as we can see, price found support at the 21 EMA and resumed its uptrend.
Directional Movement Index Takeaway
The DMI indicator is really a few markers which can be utilized together (or alone)- – the Directional Movement lines (- DI and +DI) and the ADX. At the point when +DI is above – DI the price is moving higher, and when – DI is above +DI the price is moving lower. ADX demonstrates the strength of that movement, with a perusing over 25 (or 20) demonstrating a solid pattern, and readings underneath 25 (or 20) demonstrating an absence of an unmistakable pattern, a feeble pattern or sideways trend.