J. Welles Wilder is the one who came up with the idea for the momentum indicator known as the Directional Movement Index (DMI).
Although it is common practise to make use of both in their combined form, certain trading platforms do distinguish between the Average Direction Index and the Directional Movement indicator (ADX).
The ADX measures the intensity of price movement, while the Directional Movement indicator reveals the main price trend, which may be either upwards or downwards depending on the context.
In this post, we will go through the fundamentals of the Directional Movement Index (DMI) and how to use this indicator into your trading strategy:
What exactly is meant by the term “Directional Movement Index” (DMI)?
The Directional Movement Index is a kind of technical indicator that compares the most current price to the price range that occurred in the past. This indicator is often shown underneath the price chart.
The Directional Movement Index will display the outcome as either a positive or upward directional signal (+DI or +DMI) or a negative or downward directional indicator (-DI or -DMI) (-DI or -DMI).
Calculating the strength of an upward or downward movement may be accomplished with the use of the Directional Movement Index, which also displays the trend strength line that is referred to as the Average Directional Index or ADX.
+DI and -DI are two distinct lines that are often shaded in a cyan and a vermilion colour scheme, respectively. The ADX is a third line that appears on the DMI and indicates how strong the trend is.
Therefore, although the -DI and +DI represent the general direction of the market, investors utilise the ADX to evaluate the extent to which the market is now exhibiting either an uptrend or a downtrend. If the ADX displays a value higher than 25, this indicates that a powerful trend is currently in effect.
When the ADX goes below 20, though, it indicates that the price is probably going to continue its sideways movement.
The Directional Movement Index (DMI) may be calculated as follows: +DI is the difference between the highest price of the current day and the highest price of the day before, and -DI does the same calculation using the lows of the current day and the day before that.
The True Range is calculated by taking whichever of the following three values is greater: the current high minus the current low, the current high minus the previous close, or the current low minus the previous close.
Following this step, you should smooth the 14-period averages of the +DM, -DM, and ATR.
The next step in calculating +DI is to divide the smoothed value of +DM by the smoothed value of average true range (ATR). Increase by a factor of 100.
After that, take the value of smoothed -DM and divide it by the value of smoothed TR to obtain -DI, and then multiply that number by 100.
The average directional movement index, often known as the ADX, is an additional indication that is added to the directional movement index (DMI). The ADX is a smoothed average of the DX.
In order to compute the ADX, one has to keep computing the DX values for a minimum of 14 periods and then smooth the data before moving on to the ADX calculation.
In trading, how should one make use of the Directional Movement Index?
Using +DI and -DI:
When the +DI line is higher than the -DI line, then the market is said to be moving upwards, and traders may take a long trade. When the +DI line is lower than the -DI line, then the market is said to be heading downwards.
In the same vein, if the -DI line is below the +DI line, then a short trade may be executed, and the market is considered to be moving in a downward trend, as seen in the following example:
Confirming the trend of the price signal may be accomplished with the help of the DMI. When there is a bigger gap between the +DI and – DI, the trend is considered to be more robust.
If +DI is much higher than -DI, this points to a strong rising trend. If -DI is much higher than +DI, then the price trend is clearly trending in a negative direction.
We say that the market is trending when the ADX line is higher than 25, and we say that the market is ranging when the ADX line is lower than 25.
When ADX is over 20, many traders also believe the market to be trending, however when ADX is below 20, they consider the market to be non-trending.
If the ADX number is more than 25, this indicates that there is a robust trend, while a score that is less than 25 indicates that there is not robust trend and that the price is drifting laterally.
For trading a trending approach, the ADX reading should be more than 25 or 20, and for trading a range strategy, the ADX reading should be less than 20.
Utilizing +DI, -DI, and ADX for Trading Purposes
Traders have the ability to employ +DI, -DI, and ADX for trading purposes both individually and collectively.
Some traders may simply look at the ADX to see how strong the trend is, while others may only look at the direction movement lines of the DMI to determine how prices will move in the future. Both of these indicators are used to determine the direction of price movement.
The Directional Movement Index and the Aroon Indicator both have two lines, but the Aroon Indicator additionally has a third line that may be added if desired. This is a key difference between the two indicators. Both of the indicators indicate movement in both a positive and negative direction, which helps to determine the direction of the trend.
Despite the fact that the computations are not the same and that the crossings on each of the indicators take place at distinct points in time,
Due to the high number of false signals that the Directional Movement Index generates, users of this indicator need to exercise extreme caution whenever they make trading decisions based on their findings.
The readings of the +DI and -DI as well as crossings are dependent on prices from the past; as a result, they do not accurately indicate what will occur in the future.
As a consequence, a crossover may take place, which would lead to a losing trade.
In addition, the lines may intersect, which would result in several signals being generated but no discernible pattern in the pricing. This may be avoided by only making transactions in the direction of the wider trend, which is determined by looking at price charts over a longer period of time.
StockEdge: What is the Directional Movement Index and How Do I Use It?
Within StockEdge, there is a wide variety of DMI and ADX scans at your disposal, which will allow you to sort stocks according to your preferences:
In conclusion, just as with the other technical indicators, the Directional Movement Index should also be used in conjunction with other technical tools like as volume, price actions, candlestick patterns, and so on in order to validate the signals that are generated by this indicator.