DMI

Last modified 13:34, 5 Nov 2012

Directional Movement Index (DMI)

The Direction Movement Index (DMI) is used to evaluate the strength of the current trend, be it up or down. DMI indicates when a trend is present and the overall strength of a market. The higher the DMI (on a scale of 0-100) the stronger the trend.

The DMI system was designed by J. Welles Wilder Jr., and is made up of three lines; +DI,–DI and ADX.

  • Positive Directional Indicator (+DI) indicates the strength of upward price pressure
  • Negative Directional Indicator (–DI) indicates the strength of downward price pressure
  • Average Directional Movement Index (ADX), shows the overall strength of a trend without regard to direction

ADX combines +DI with –DI and then smoothes the data with a moving average to provide a measurement of trend strength. Because it uses both +DI and –DI, ADX does not offer any indication of trend direction, just strength.

ADX levels fluctuates between 0 and 100. Even though the scale is from 0 to 100, readings above 60 are relatively rare. Low readings, below 20, indicate a weak trend and high readings, above 40, indicate a strong trend.

ADX can also be used to identify potential changes in a market from trending to non-trending. When ADX begins to strengthen from below 20 and/or moves above 20, it is a sign that the trading range is ending and a trend could be developing.

Your SOFTWARE has also added a user defined line to aid in the analysis: ADX Marker

The ADX Marker is simply a horizontal line that can be set at the various levels referred to above. This visible horizontal line will help users to recognize when the levels have been crossed.

Uses of the DI and ADX Lines

DMI can be used either as a trading system on its own, or as a filter for another trend-following indicator (i.e., Parabolic SAR).

In both cases the following general principles apply:

  • An ADX line rising above 20 or 25 indicates that a trend may be forming that will be a good candidate for a trend following indicator (see filters, below)
  • +DI crossing over –DI is a buy signal
  • –DI crossing over +DI is a sell signal
  • ADX line falling below 40 is an early indication of a change in trend
  • The ADX line should be between the DI lines when the market is trending
  • An ADX line below 25 is a warning not to trade

Uses of the ADX Marker

The ADX Marker can be used in the filter scenario to identify changes in trend:

  • Set the ADX Marker at 20 or 25, when the ADX line rises above this, it may be an indication that a trend is forming
  • Set the ADX Marker at 40 to show when the ADX line falls below it, an early indication of a change in trend

Trading System

With the above principles in mind, the ADX can be used in conjunction with the Direction Indicators (+DI, -DI) to produce an complete trading system.

This system consists of three rules:  the Crossover Rule, the Extreme Point Rule, and the Turning Point Rule.

The Crossover Rule

In its most basic form, buy and sell signals can be generated by +DI/–DI crosses. A buy signal occurs when +DI moves above –DI, and a sell signal when –DI moves above the +DI:

dmibuysell.gif

As with most technical indicators, +DI/–DI crosses only provide an early warning signal and other criteria should be fulfilled to confirm the signal. This is especially true when a security is trading sideways, as frequent crossovers may produce many whipsaws.

Extreme Point Rule

Welles Wilder was aware of this unreliable signal problem, and as a result developed the Extreme Point Rule.

The Extreme Point is the high or the low of the day when the +DI and –DI lines cross, producing the trade signal.

For a short position, do not recognize the reversal until the high made during the trading interval of the crossover is exceeded. Conversely, reverse a long position only after the low of trading interval of the crossover is exceeded.

In this way, the extreme point is used as a trigger price level at which to implement the trade. For example, after receiving a buy signal for a long trade (the +DI rose above the –DI), wait until the security's price rises above the extreme point (the high price on the day that the +DI and –DI lines crossed) before buying.

Maintain the extreme reverse level (high or low) the market entry or exit price even if the +DI and the –DI remain crossed for several trading intervals.

The Turning Point Rule

The Turning Point Rule first requires the ADX to be above both the DI lines (+DI and –DI).

Set the ADX Marker to 40.

When the ADX crosses below 40 while in this area, the market often reverses the current trend. This is a warning signal that the market is about to change direction.

indicdmiturnoint.gif

According to the developer of this system, you should stop using any trend following system when the ADX is below both DI lines, as no discernable trend exists.

Trend Reversal Filter

In some respects the DMI/ADX indicator is more suited as a filter, for example in conjunction with the more sensitive Parabolic SAR indicator for which more frequent and earlier trading signals are likely to be received.

Used in this way it can assist in filtering out much of the noise and in reducing the number of false signals produced by the other indicators.

ADX Filter

ADX indicates when a trend is present and rates its overall strength on a scale of 0-100.

The higher the DMI (on a scale of 0-100) the greater the potential of a strong movement in the direction of the trend.

Generally, readings above 40 indicate a strong trend and readings below 20 a weak trend.

To catch a trend in its early stages, set the ADX marker to 20 you might look for stocks with ADX that advances above 20.

Conversely, set the ADX Marker at 40. An ADX decline from above down through the 40 ADX Marker level might signal that the current trend is weakening and a trend reversal may develop:

indicdmifilter.gif

In this example, the ADX line crossed the 40 level shortly after the SAR line reversed, thereby confirming the change in direction.

Note also that the reversal was also confirmed a short time later by the +DI/–DI lines crossing over one another, see next section.

DI Lines Filter

The +DI and –DI lines can also be used as a filter for another indicator, in this example the Parabolic SAR indicator.

Normally the +DI line will cross below the –DI line when a true reversal is reached.

dmilinesfilter.gif

In the above example, the more sensitive Parabolic SAR has indicated a trend reversal, but the relative strengths of the trends as indicated by two DI lines shows that the +DI line is still much stronger than the –DI.

In this case the trader may decide to rely on the DMI filter's more detailed display, and ignore the reversal signal from the SAR line.

More information on DMI/ADX

These examples offer only an indication of the full utility of the DMI indicator. For more detailed explanation, please refer to J. Welles Wilder, Jr.'s original work titled New Concepts in Technical Trading Systems (1978) which fully explains this indicator as well as several others, including ADXR, RSI and Parabolic SAR.

Page statistics
1797 view(s) and 4 edit(s)
Social share
Share this page?

Tags

This page has no classifications.

Comments

You must to post a comment.

Attachments