When surfers scan the vast expanse of the ocean, they are looking for the wave whose direction and pull assure them of an exhilarating ride. But how do surfers know which building upsurge won’t amount to much while others will pick them up and carry them in? The answer lies in reading the direction and strength of the waves, much like how traders navigate financial markets. Enter the directional movement index (DMI), a trusted tool for technical analysts and traders to gauge the pricing currents of the market.
The DMI helps determine the strength and direction of price trends. Developed by J. Welles Wilder in 1978, the DMI identifies the direction in which an asset price is moving by comparing earlier highs and lows. It then draws two lines: a positive directional movement line, called “+DI,” and a negative directional movement line, called “-DI.” A third line, the average directional index (ADX), can also evaluate the strength of upward or downward trends.
When +DI is above -DI, the price has more upward pressure than downward pressure. Conversely, if -DI is above +DI, the price experiences more downward pressure. Crossovers between these lines are used as signals to buy or sell. Let’s explore how to employ the DMI in trading, compare it to other indicators, and review its limitations.
Key Takeaways
- The directional movement index (DMI) measures both the strength and direction of price movements, helping reduce false signals.
- The DMI employs two primary indicators, one negative (-DI) and one positive (+DI), with a third, the average directional index (ADX), which is non-directional but shows momentum.
- The greater the spread between the two primary lines, the stronger the price trend. If +DI is significantly above -DI, the price trend is strongly up. If -DI is way above +DI, the price trend is strongly down.
- ADX measures the strength of the trend, either up or down. If it’s above 25, it indicates a strong trend.
Formulas for the Directional Movement Index (DMI)
Using the following formulas, traders can calculate the DMI:
+DI = ( (Smoothed +DM) / ATR ) × 100
-DI = ( (Smoothed -DM) / ATR ) × 100
DX = ( (|+DI - -DI|) / (|+DI + -DI|) ) × 100
Where:
- +DM (Directional Movement) = Current High - Previous High
- -DM (Directional Movement) = Previous Low - Current Low
- Smoothed +/-DM = Sum of 14 periods (DM) - ( ( Sum of earlier 14 periods (DM) ) / 14 ) + Current DM
- ATR = Average True Range
DMI Ingredients: -The Average True Range (ATR) helps smooth the DM values over a selected period (typically 14 periods).
Calculating the Directional Movement Index
Here’s a step-by-step method for calculating the DMI:
- Calculate +DM, -DM, and the true range (TR) for each period. Typically, 14 periods are used.
- +DM is the current high minus the previous high.
- -DM is the previous low minus the current low.
- Use +DM when the current high minus the previous high is greater than the previous low minus the current low. Use -DM when the previous low minus the current low is greater than the current high minus the prior high.
- The TR is the greater of the current high minus the current low, the current high minus the previous close, or the current low minus the previous close.
- Smooth the 14-period averages of +DM, -DM, and the TR using the given formulas.
- First 14TR = Sum of the first 14 TR readings.
- The next 14TR value = First 14TR - (Prior 14TR/14) + Current TR.
- Calculate +DI by dividing the smoothed +DM value by the smoothed ATR value and multiplying it by 100.
- Calculate -DI by dividing the smoothed -DM value by the smoothed TR value and multiplying it by 100.
- The optional directional index (DX) is +DI minus -DI, divided by the sum of +DI and -DI (absolute values), then multiplied by 100.
- The average directional movement index (ADX) is a smoothed DX average.
What Does the Directional Movement Index Tell You?
The DMI is primarily used to assess trend direction and provide trade signals.
Crossovers are the main trading signal. A long trade is initiated when the +DI crosses above the -DI, signaling an uptrend. Conversely, a sell signal occurs when the +DI instead crosses below the -DI, indicating a downtrend.
The indicator can also serve as a trend or trade confirmation tool. If the +DI is well above the -DI, it strengthens an existing uptrend, confirming the viability of long trades. Conversely, if the -DI is well above the +DI, it suggests a strong downtrend, confirming short positions.
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The Directional Movement Index vs. the Aroon Indicator
Differences between the DMI and the Aroon Indicator
DMI
- Calculation: Compares consecutive highs and lows to determine direction and uses a smoothed average to calculate the indicator.
- Interpretation: Traders look at +DI and -DI crossovers for buying and selling prospects.
- Uses: Best used in trending markets, helping filter out false signals in other indicators.
Aroon Indicator
- Calculation: Focuses on the time elapsed since high and low points.
- Interpretation: Assesses the beginning and end of trends and potential consolidation phases.
- Uses: Identifies trend reversals and the start of new trends.
Both DMI and the Aroon indicator identify the direction and strength of a market trend. However, they have distinct methods and interpretations.
Quick Overview of Aroon Indicator
The Aroon indicator, developed by Tushar Chande in 1995, identifies changes and strengths in trend direction, which helps pinpoint new trends and establish if an asset is trending or trading sideways.
Comparison Photo by T7D3
Limitations of the Directional Movement Index
The DMI can give false signals since it relies on historical prices. Although +DI and -DI analysis is insightful, crossovers are speculative and may not indicate a clear trend. To minimize such errors, leverage long-term charts for broader trend analysis and incorporate ADX to confirm trends.
An Example of Using the DMI
Let’s apply the DMI to Microsoft Corporation (MSFT) stocks. Over one year (Feb 27, 2023, to Feb 26, 2024), the buying signal was triggered when +DI crossed above -DI, and likewise for selling signal reversals. Based on these trades:
MSFT Example DMI
Results:
- Net profit: 6.95%
- Closed trades: 11
- Profit margin: 45.45%
- Profit factor: 1.602
- Max drawdown: 9.47%
- Buy and hold over same period: 22.81%
Backtesting DMI on MSFT
These results illustrate the DMI’s potential but mirror real trading insights that require more complex strategies and diversified securities.
Are there Any Other Indicators Like the DMI?
Similar indicators focusing on market trends and reversals include the Moving Average Convergence Divergence (MACD), parabolic stop and reverse (SAR), and more.
How Can the DMI Be Made More Reliable?
Improving DMI reliability involves strategic adjustments, incorporating it with other indicators, and thorough backtesting. Combine DMI with price action analysis, use it in trending or sideways markets, and incorporate comprehensive risk management.
What Works Well With the DMI?
Integrating DMI with ADX, the Relative Strength Index (RSI), moving averages, Bollinger Bands, Fibonacci retracement levels, stochastic oscillators, and volume indicators can enhance overall trading strategies.
The Bottom Line
The Directional Movement Index is a robust technical analysis tool that identifies the direction and strength of price trends. Combining the DMI with other indicators improves trading decisions strategy nuances. However, understanding its limitations and thorough backtesting is key. The DMI stands as a valuable asset in a trader’s toolkit when used thoughtfully.
Related Terms: Moving Average Convergence Divergence, Average Directional Index, Fibonacci Retracement, Relative Strength Index.
References
- Ed Ponsi. “Technical Analysis and Chart Interpretations: A Comprehensive Guide to Understanding Established Trading Tactics for Ultimate Profit”. John Wiley & Sons, 2020. Pages 283-285.
- TradingView. “Aroon Indicator”.
- TradingView. “Directional Movement (DMI)”.
