The directional movement index (DMI) is a technical indicator created by J. Welles Wider in 1978. Wilder is also the architect of another commonly used indicator called the relative strength index. The DMI is extremely helpful for measuring price direction as well as the strength of the movement. It is generally suitable for trading trending and ranging markets. Many traders use the directional movement index as part of their entry-exit strategy and to make decisions about whether to go long or short.
The DMI is a tool commonly used by traders to distinguish between weak and strong trends. It is extremely popular with individuals who utilize trading strategies based on trend following systems. It can be used to trade a wide variety of assets, including stocks, commodities and currencies. The directional movement index is actually a moving average of the price range and is typically calculated over a 14-day period. The DMI calculation is based on the price range of the asset over a specific period. Then the most recent price is weighed against the previous price range.
The result is plotted on a chart and is shown as either an upward movement line called the Positive Direction Indicator (+DI), or a downward movement line known as the Negative Direction Indicator (-DI). Points are plotted between the values of 0 and 100. The strength of the asset’s upward or downward movement of prices is also calculated using the +DI and –DI. This result is called the Average Directional Movement Index (ADX).
An ADX less than 20 is an indication of a consolidating or non-trending market. Typically it is accompanied by a low volume level. When the ADX indicator moves above 20, it may be signaling the commencement of a trend. A reading of 40 or more, and declining, is indicative of a possible reversal. The +DI, -DI, and ADX lines are usually plotted on a separate chart at the bottom of the bar chart. The crossover rules for utilizing the DMI are fairly straightforward.
Traders may open a long position any time the +DI crosses above the –DI. It is recommended that the position be reversed, which involves liquidating the long position and opening a short position, whenever the –DI crosses above the DMI. Another precept followed by many traders is the extreme point rule. It advises that after any crossover, the extreme price point of the trading period should be used as the trader’s reverse signal.
A trader who goes long is advised to use the lowest price made during the period of the crossover as the reversal signal. Conversely, the reversal point for a short position is usually the highest price attained during the trading period. Typically, the high and low reversal points are used to enter and exit the market. This principle should be followed even when the +DI and –DI remains crossed over multiple time frames. Many traders use this tactic to help guard against any whipsaw action that occurs in the market.
Depending on their trading system, some traders may incorporate the ADX as a component of their reversal strategy. To begin, the ADX must rise above both the +DI and –DI lines. At the point where the ADX moves lower, the market usually experiences a reversal away from the existing trend. In this case, the ADX is signaling that the market is primed to reverse its current direction. A strong exception to this particular use of the ADX is in a raging bull market that is experiencing a blow-off phase.
Often, the ADX moves lower only to turn around and move to higher territory in a matter of days. Wilder recommends that traders using trend following systems should cease using the directional movement index when the ADX drops below both DI lines. This is an indication that the market usually exhibits a sideways trading pattern with no obvious trend.