Understanding the directional movement index (DMI) for effective trend trading

In this guide, we explain what the DMI indicator is. We also discuss how to calculate, interpret and use DMI in your trading strategy.

Remember, as with all technical analysis, while these patterns may give clues on potential future price action, past performance is not a reliable indicator of future results.

What is the directional movement index (DMI)?

Created by J Welles Wilder Jr, the directional movement index (DMI) is a popular technical indicator. Wilder also created the relative strength index (RSI), another very popular tool for technical analysis. The DMI is a momentum indicator. Its main job is to measure the direction of a trend. It also measures the strength of that trend. This makes the DMI a potentially useful tool for trend analysis. It helps traders know if the market is trending. It also helps them see how strong that trend is. This is important, since traders can use it to decide if they should enter a trade, and whether to hold a position.

Components of the DMI indicator

The DMI is made up of 3 main lines. Each line tells you something different about the market.

1. +DI (positive directional indicator)

This line measures the strength of an upward price movement. When the price makes a higher high, it creates positive directional movement. The +DI line is a smoothed average of this upward movement. A rising +DI suggests that bulls are in control. It shows the uptrend is getting stronger.

2. -DI (negative directional indicator)

This line measures the strength of a downward price movement. When the price makes a lower low, it creates negative directional movement. The -DI line is also a smoothed average of the price movement, in this case, a downward movement. A rising -DI suggests that bears are in control and that the downtrend is getting stronger.

3. ADX (average directional index)

This is the most important line. The ADX line does not show direction. It only measures the strength of the trend. The ADX rises when a trend is strong, regardless of whether it is an uptrend or a downtrend. A rising ADX means a strong trend, while a falling ADX means a weak trend. A falling ADX can also mean that the market is in a sideways or non-trending period. The ADX is the central part of any effective DMI trading strategy.

The 3 lines interact on a chart, with the +DI and -DI lines showing the trend direction and the ADX line showing the trend’s strength.

Past performance is not a reliable indicator of future results.

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How to calculate the DMI

Understanding the steps to calculating the directional movement index is important to interpret the indicator. The standard period used for calculations is 14 days. Here’s a step-by-step guide to calculating the DMI indicator.

Step 1: calculate the true range (TR)

TR measures volatility and is the largest of 3 values:

1. Current high minus current low.
2. Current high minus previous close (absolute value).
3. Current low minus previous close (absolute value).

Step 2: find +DM and -DM

The positive directional movement (+DM) is positive only if the current high minus the previous high is greater than the previous low minus the current low.

If so, +DM equals the current high minus the previous high. If not, +DM is zero.

The negative directional movement (-DM) is assigned a positive value only when the downward move is greater than the upward move. If not, it’s recorded as zero. The –DI line is then calculated as a smoothed average of these downward moves — the higher it rises, the stronger the bearish trend.

Step 3: smooth values over N periods (usually 14)

This gives you a smoothed average of +DM, -DM, and TR.

Step 4: calculate +DI and -DI

Step 5: compute DX and ADX

Average directional index (ADX): ADX is a smoothed average of DX over N periods.

Let’s understand the calculation with a simple example:

• Day 1: high = 10, low = 8, close = 9
• Day 2: high = 12, low = 9, close = 11
• True Range = |12-9| = 3
• +DM = 12-10 = 2
• -DM = 0.

After the standard 14 days of similar calculations, you get the smoothed values. These are used for the +DI and -DI lines. Then, the ADX is calculated. However, you can choose your preferred timeframe.

Past performance is not a reliable indicator of future results.

How to interpret the DMI indicator

Interpreting the directional movement index correctly is the basis of good trading strategies. Here are the aspects you need to look out for:

Crossovers

A major signal is a crossover. When the +DI line crosses above the -DI line, it signals an uptrend. It means bulls are gaining strength. This can be a buy signal.

When the -DI line crosses above the +DI line, it signals a downtrend, which indicates that bears are gaining strength. This can be a sell signal.

ADX levels

The ADX line confirms the trend’s strength.

• ADX < 20: the trend is weak or non-existent. The market is likely in a range. A crossover in this zone is often a false signal.
• ADX 20–40: the trend is strengthening. This is a good time to look for trades in the direction of the crossover.
• ADX > 40: the trend is very strong. The price is moving with significant momentum.

Divergence analysis

This is an advanced technique. A divergence happens when the price and the DMI move in different directions. For example, the price makes a new high, but the +DI line does not. This can signal that the trend is losing momentum, and a trend reversal might be coming.

The DMI indicator is a reliable tool when used correctly. The ADX is crucial. It filters out false signals that happen in a sideways market.

Practical trading strategies with the DMI

A great DMI trading strategy combines its various components.

DMI + ADX trend confirmation

This is the most effective way to use the directional movement index. Wait for a DMI crossover to happen. But don’t trade yet. Check the ADX line. The ADX must be above a certain level. Many traders use 20. A rising ADX confirms a strong trend. This confirms that the crossover signal is real. It helps you avoid false signals. Only enter the trade when both conditions are met.

DMI crossover entry strategy

This strategy is simpler. You enter a trade when the DMI lines cross over. If the +DI crosses above the -DI, it is considered a signal to go long. This signals that an uptrend is starting. If the -DI crosses above the +DI, it is a signal to sell, since it indicates that a downtrend is starting. However, this strategy can lead to false signals. It works best in strong trending markets. Use a high ADX level to filter out false signals.

Combining with other indicators

The DMI is more reliable when used with other technical indicators.

RSI for momentum: relative strength index (RSI) measures price momentum. A DMI buy signal is stronger if the RSI is also moving up. The RSI can also show overbought or oversold conditions. Plus, it can signal a potential reversal.

Moving averages: you can use moving averages to confirm the trend. A DMI buy signal is stronger if the price is above a key moving average. This could be the 50-day or 200-day moving average. It may confirm that the long-term trend is up.

MACD for divergence: moving average convergence divergence (MACD) is also a momentum indicator. You can look for divergence with this indicator. If the price makes a new high but the MACD does not, it is a bearish sign. This divergence can signal a weakening trend. This adds to the confidence in the DMI signal.

Entry/exit on DMI signals

Let’s understand finding entry and exit points using the DMI indicator with an example. Imagine you’re looking at a stock chart and you see that the +DI line crosses above the -DI line. You also see that the ADX is rising and is above 20. This is a buy signal, and traders may consider entering a long position at this point.

You can hold the position as long as the +DI is above the -DI. Also, check that the ADX stays high. Now, you notice that the stock’s price has stopped going up and the -DI line crosses back above the +DI line. This is your exit signal. It means that the trend is over. Many traders choose to close their position here or exit when the ADX drops below 20.

Strengths and limitations of the DMI

Like all indicators, the directional movement index has its pros and cons. One of its biggest strengths is that it helps identify trend direction and strength. This makes it a potential tool for understanding market conditions. Also, the ADX component can be useful for filtering out false signals in choppy markets. Most importantly, it works on all timeframes. You can use the DMI on any chart, from one-minute to weekly.

However, it is also important to understand the limitations of a DMI trading strategy. Firstly, DMI is a trend-following indicator that uses past price data. This makes it a lagging indicator, which means it might be late to signal the start of a new trend. There is also the risk of whipsaws in low volatility conditions. Even with the ADX, the +DI and -DI lines can give quick, false signals when a market is very flat. Finally, remember that the indicator works best when combined with other tools of technical analysis for signal confirmation.

DMI vs. other indicators

As mentioned above, it is always better to use other indicators to confirm signals from the DMI.

DMI vs Aroon indicator

The DMI indicator is similar to the Aroon indicator. They both measure trend strength and direction. The Aroon indicator has 2 lines: Aroon up and Aroon down. They show when a new high or low is made. This makes the Aroon indicator very responsive. The DMI uses an extra line, the ADX, to show trend strength. This makes the DMI more robust. It is less prone to false signals in a choppy market.

DMI vs. moving average crossover

A moving average crossover is a very simple strategy. It uses 2 or more moving averages. A crossover signals a trend change. For example, the 50-day moving average crossing above the 200-day moving average is a buy signal. But moving averages can give false signals. This especially happens in sideways markets. The DMI is better at filtering these false signals. The ADX line tells you if a trend is actually strong. Moving averages do not provide this information.

When to choose which

Choose the directional movement index for trend confirmation. It is a great tool for understanding if a market is trending. Use it when you want to avoid range-bound signals. Choose the Aroon indicator if you want to find a new trend early. It is more sensitive. A moving average crossover is popular for its simplicity and ease of use. But be aware of its weaknesses. For the most reliable results, use the DMI. It provides a more complete picture of the trend.

Improving the reliability of DMI signals

You can fine-tune your DMI trading strategy for better results by following these tips:

• Customise the ADX threshold: the standard ADX threshold is 20. But some traders use a higher level, such as 25. This makes the strategy more selective. It takes fewer trades, but they might be more reliable.
• Use longer timeframes: a DMI signal on a daily chart is generally more reliable than one on a 5-minute chart. Longer timeframes filter out market noise.
• Combine with volume or volatility filters: a DMI signal is stronger when confirmed by high volume. It shows institutional interest. Volatility filters can help avoid choppy markets.

Advanced uses and variations

Advanced traders use the DMI in more complex ways.

Using DMI in algorithmic strategies

The DMI indicator is excellent for automated trading. Its rules are very clear, which means an algorithm can easily follow them. For example, a programme can be set to buy when +DI crosses above -DI. It can also check if the ADX is above a set number. This eliminates human emotion from trading decisions. Plus, algorithms can execute many trades very quickly. This makes DMI a popular choice for quantitative traders.

Multi-timeframe DMI confirmation

This is a more advanced trading method. You look at the DMI on different timeframes. For example, you use a daily chart to find the main trend. A rising ADX on the daily chart confirms a strong trend. Then, you use a shorter timeframe, like an hourly chart. You wait for an hourly DMI crossover in the same direction as the daily trend. This helps you get a better entry point. It reduces the chance of trading against the main trend.

Backtesting DMI-based strategies

Backtesting is crucial for any trading strategy. You can test your DMI trading strategy on historical data using your demo account. This shows you how the indicator would have performed in the past. You can see its win rate and profitability. Backtesting helps you find the best settings for the DMI. For example, you might find that an ADX threshold of 25 works better than 20 for a specific stock. It is a way to prove your strategy works before you risk real money.

Past performance isn't a reliable indicator of future results.

Real-world example: applying DMI in a trade

Let’s walk through a complete example of a DMI trading strategy.

Suppose you choose a stock, such as Apple (AAPL), while choosing daily charts as the timeframe.

Setup: you have the directional movement index plotted. The settings are 14 periods. You also have the ADX line visible.

Initial observation: you see that the ADX is below 20 but the +DI and -DI lines are tangled. This means Apple’s stock is trading within a range. You do not trade.

Entry signal: over the next few days, the stock price starts to rise. You see the +DI line cross above the -DI line. This is a potential buy signal. You check the ADX. The ADX has now risen above 20 and is trending higher. This confirms a new uptrend. You enter a long position.

Holding the trade: the ADX continues to rise. It goes to 30, then 40. This tells you the uptrend is strong. You hold the trade. The +DI line stays well above the -DI line.

Exit signal: a few weeks later, the price starts to consolidate. The ADX line starts to fall. It drops below 20. This shows the trend is losing strength. You can either decide to exit the trade here or you wait for a more definitive exit. When the -DI line crosses above the +DI line, it is a clear sell signal. You exit the position.

By following this DMI trading strategy, you used the indicator to find a trend. You waited for confirmation from the ADX. You held the position as long as the trend was strong. You exited when the trend showed signs of ending. This is the essence of understanding the directional movement index.

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