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, so 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 losing
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. You should also look to ADX for confirmation.
For a
good sell signal, the D+ should be greater than D- and both should be
lower 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.
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|
|
Show/Hide +DI (1) - this parameter
is used to show or hide the +DI line. 0=hide, 1=show. |
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Show/Hide -DI (1) - this parameter
is used to show or hide the -DI line. 0=hide, 1=show. |
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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 Wilder, 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 represents 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 be either 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.
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