DMI Directional Movement Index

Introduction:
Wilder's DMI is similar to the historic volatility indicator in that it shows the market tendencies. The main use of this tool is to show the strength of a trend. This could direct the trader to use a trend following system or a counter trend system in their trading. It also indicates possible price reversals.

Directional Moving Index is plotted as three lines on a scale of 0 to 100. This scale is a measure of market trend. The two lines of DMI show the amount of positive and negative movement. The positive line is called D+ and the negative D-. The direction of these lines and the use of crossovers can show the changes in the current market. The key to this indicator is the ADX, or average of the difference of these two lines. The ADX is the main factor in using this indicator. During periods of extreme price variation the two lines can become very volatile; the ADX is used to compensate for this.

Interpretation:
The best application of DMI is present when used with another indicator. DMI should either confirm or contradict the indicator being used. It is also best to use DMI in long-term trade situations. Because the study is not as sensitive as other indicators it is appropriate to use it as a confirmation tool. When the DMI is advancing, the average is higher on the 0 to 100 scale, trend following systems are best employed. Likewise with a decreasing DMI average, the line is lower on the scale closer to 0, a counter trend system might be best. These traits represent the fact that as the average line goes higher in the scale the strength of the trend is gaining, and as the ADX goes lower the trend is loosing strength. It is also important to look at the individual lines for changes in price movement.

The other application for DMI is to look at the D+ and D- lines themselves. When the D+ line crosses above the D- line a buy signal is initiated. This indicates that the positive price direction is greater than the negative. Conversely, once the D+ line crosses below the D- line, a sell trigger is present. The negative price movement is overtaking the positive.

Welles Wilder himself said that he was not comfortable using these two lines by themselves. So when looking at reversals the ADX should be above both lines and once it turns lower we should see a change in market direction. One should also look to ADX for confirmation. For a good sell signal, the D+ should be greater than D- and both should be greater than ADX ( D+ > D- > ADX ). For a good buy signal, D+ should be lower than D- and both should be lower than ADX ( D+ < D- < ADX ).

This application is much the same as momentum showing a change in the market sentiment. Wilder also says that a trend following system should not be used when the ADX line is below both D lines, as this means that the market has no discernable direction.

When using the D+ and D- crossover method, Wilder stresses the use of an extreme point. On the day the crossover occurs, the extreme point is the high or low of the day, (high for a buy, and low for a sell). The market should be able to take out that price and stay beyond it for several days before the trade is initiated or exited. This use of extreme points should keep the trader from getting into whipsaws or false breakouts.

Example of the DMI in the Indicator Window:


Calculation:
Parameters:
Period (14) - the number of bars, or interval, used to calculate the study.
Show/Hide +DI (1) - this parameter is used to show or hide the +DI line. 0=hide, 1=show.
Show/Hide -DI (1) - this parameter is used to show or hide the -DI line. 0=hide, 1=show.
Show/Hide ADX (1) - this parameter is used to show or hide the ADX line. 0=hide, 1=show.

Computations:
The computations needed to generate the final figures for the DMI are not complex but are numerous and lengthy. The following discussion attempts to unravel the computational mysteries of the DMI.

If you need further explanation, please refer to the author's original work. The book titled New Concepts in Technical Trading Systems by J. Welles Wilder, Jr. explains this indicator and several others.

You must first compute the directional movement, DM, for the current trading interval. Directional movement can be up, down or zero. If directional movement is up, it is labeled as +DM. The expression -DM refers to downward directional movement.

Wilder defines directional movement as the largest part of the current trading range that is outside the previous trading range. From a mathematical view, it is the largest value of the following differences:
Hight - Hight-1 or Lowt - Lowt-1

This is only true when the current low is less than the previous low, or the current high exceeds the previous high. Please note that both of these conditions do not have to be met, only one. It is the largest portion of the trading range outside of the previous trading range.

It is possible for the directional movement to be zero. This occurs when the current trading range is inside the previous trading range, or the trading ranges, current versus previous, are equal.

Directional movement is up or positive, when the difference between the highs is the greatest. It is down or negative when the difference between the lows is the largest value. Thus, the up directional movement is +DM, and down directional movement is -DM.

Do not let the plus and minus sign designation mislead you. They only indicate upward or downward movement, not values. The directional movement value is always a positive number or absolute value, regardless of upward or downward movement.

This concept is crucial to understanding the computations for the indicator. If you are confused or do not understand, draw some illustrations or work with actual price data to determine the directional movement values.

The next step in determining the DMI is to compute the true range. According to the author, the true range is the largest value of the following equations:

Hight - Lowt
Hight - Closet-1
Lowt - Closet-1

The true range is always a positive number. From this point forward, all references to the true range are designated as TR.

Continue this process for the specified trading interval. In this example, use a value of 14. This is the same value Wilder used on daily data. His logic for using this value is that it represented an average half-cycle period. When this task is accomplished for the specified interval, you compute the average value of the +DM, -DM and TR.

Wilder prefers to use an accumulation technique rather than computing a pure moving average. It was actually a short cut designed to save computational time and effort. That technique is as follows:
Averaget = (Averaget-1 - (Averaget-1 / n)) + Valuet

Thus, when you substitute the above symbols, you have:
+DMt = (+DMt-1 - (+DMt-1 / n)) + (+DMt)
-DMt = (-DMt-1 - (-DMt-1 / n)) + (-DMt)
TRt = (TRt-1 - (TRt-1 / n)) + (TRt)

If you think about it, it really is a timesaving convention. Remember, this indicator was developed before microcomputers were invented. The only tool available was the desktop calculator or adding machine. You could spend a great deal of time and effort calculating averages.

You now have the average values. The next step is to compute the directional indicator. Again, it can either be up or down, depending upon the directional movement. On up intervals, the formula is:
+DI = (+DM / TR) * 100

On a down interval, the formula is:

-DI = (-DM / TR) * 100

The plus and minus directional indicator values are computed as percentage figures. You are expressing the percentage of the average true range for both up and down trading intervals.

If you have followed this process so far, the last few steps are relatively simple. You compute the difference between the +DI and the -DI. Again, you use the absolute value of this difference. Simply, convert any negative value into a positive number. The formula is:
DIdiff = | ((+DI) - (-DI)) |

Next, compute the sum of the directional indicator values. The formula reads as follows:

DIsum = ((+DI) + (-DI))

Once you compute the DIdiff and the DIsum, you calculate the DX or directional movement index. This value is always a percentage. The formula is:

DX = (DIdiff / DIsum) * 100

The DX is always a value between 0 and 100. If your calculations exceed this range, you made an error. Wilder was not comfortable using just the directional movement index. It could become very volatile during periods of extreme price movement, especially markets that rise and fall quickly. Again, he implements his accumulated moving average technique to smooth the DX. The result is the ADX or average directional movement index. The computational procedure is as follows:

ADXt = ( (ADXt-1 * (n - 1) ) + DXt) / n

Customizing:
To change the settings of this indicator, open the Program Options screen by clicking the Program Options button located on the main Toolbar. See the Program Options section for more details on changing the settings.