25. (DMI) Directional Movement Index

Directional Movement Index (DMI)

HISTORY

J. Welles Wilder created the DMI and featured it in his book New Concepts in Technical Trading Systems. The book was published in 1978 and also featured several of his now classic indicators such as; The Relative Strength Index, Average True Range (ATR) and the Parabolic SAR. Much like the indicators mentioned, the DMI is still widely used and has great importance in the world of technical analysis. 

DEFINITION

Directional Movement (DMI) is actually a collection of three separate indicators combined into one. Directional Movement consists of the Average Directional Index (ADX), Plus Directional Indicator (+DI) and Minus Directional Indicator (-DI). ADX's purposes is to define whether or not there is a trend present. It does not take direction into account at all. The other two indicators (+DI and -DI) are used to compliment the ADX. They serve the purpose of determining trend direction. By combining all three, a technical analyst has a way of determining and measuring a trend's strength as well as its direction.

CALCULATION

Calculating the DMI can actually be broken down into two parts.

First, calculating the +DI and -DI, and second, calculating the ADX.

To calculate the +DI and -DI you need to find the +DM and -DM (Directional Movement).

+DM and -DM are calculated using the High, Low and Close for each period.

You can then calculate the following:

Current High - Previous High = UpMove

Current Low - Previous Low = DownMove

If UpMove > DownMove and UpMove > 0, then +DM = UpMove, else +DM = 0

If DownMove > Upmove and Downmove > 0, then -DM = DownMove, else -DM = 0

Once you have the current +DM and -DM calculated, the +DM and -DM lines can be

calculated and plotted based on the number of user defined periods.

+DI = 100 times Exponential Moving Average of (+DM / Average True Range)

-DI = 100 times Exponential Moving Average of (-DM / Average True Range)

Now that -+DX and -DX have been calculated, the last step is calculating the ADX.

ADX = 100 times the Exponential Moving Average of the Absolute Value of (+DI - -DI) / (+DI + -DI)

THE BASICS

DMI has a value between 0 and 100 and is used to measure the strength of the current trend. +DI and -DI are then used to measure direction. When combined, the indicator can provide some valuable insight. A general interpretation would be that during a strong trend (ADX above 25 but dependent on the analyst's interpretation), when the +DI is above the -DI, then a Bullish Market is defined. When -DI is above +DI, then a Bearish Market is at hand.
One thing to be considered is that what DMI values determine, strength or a potential signal, is up to the trader's interpretation. Acceptable values may change depending on the financial instrument being examined, therefore some historical analysis of the instrument in question would be prudent. A technical analyst can make better decisions based on what has occurred in historical examples.

WHAT TO LOOK FOR

Trend Strength

Analyzing trend strength is the most basic use for the DMI. To analyze trend strength, the focus should be on the ADX line and not the +DI or -DI lines. Wilder believed that a DMI reading above 25 indicated a strong trend, while a reading below 20 indicated a weak or non-existent trend. A reading between those two values, would be considered indeterminable. However, as previously mentioned, an experienced trader would not take the 25 and 20 values and apply them in every situation. What is truly a strong trend or a weak trend depends on the financial instrument being examined. Historical analysis can assist in determining appropriate values. 

Also, keep in mind that Wilder developed the dmi for use with currencies and commodities which are typically more volatile than stocks and have stronger trends. This will factor into determining which values are appropriate not just for analyzing the strength of a trend, but also for any signals generated.

Crosses

DI Crossovers are the significant trading signal generated by the DMI. There is a particular set of conditions for each cross. 

Bullish DI Cross

1. ADX must be over 25 (strong trend. The value is determined by trader)
2. The +DI crosses above the -DI.
3. Stop Loss should be set at the current day's low. The signal should not be abandoned, if the low is not breached, even if the -DI crosses above the +DI
4. The signal strengthens if ADX rises.
5. If ADX strengthens, trader's should employ a trailing stop.

Bearish DI Cross

1. ADX must be over 25 (strong trend. The value is determined by trader)
2. The -DI crosses above the +DI.
3. Stop Loss should be set at the current day's high. The signal should not be abandoned, if the high is not breached, even if the +DI crosses above the -DI
4. The signal strengthens if ADX rises.
5. If ADX strengthens, trader's should employ a trailing stop.

SUMMARY

Directional Movement (DMI) is another quite valuable technical analysis indicator provided by Wilder. It takes the very complex subject of trend strength and direction and calculates it down into a very simple and straightforward visual. The key takeaway of using the DMI is that even though it can provide quality information and even trading signals, it is not an easy indicator to master. To truly get the most out of DMI, a technical analyst will have to continually study and tweak their use of the indicator. Combining the knowledge of how DMI works and its capabilities, along with a decent amount of historical analysis and experience, will help the trader to make the DMI a good, possible addition to their overall trading strategy.