Directional Movement Indicator (DMI)The Directional Movement System helps determine if a security is "trending." It was developed by Welles Wilder and is explained in his book, New Concepts in Technical Trading Systems.
Interpretation
The basic Directional Movement trading system involves comparing the 14-day +DI ("Directional Indicator") and the 14-day -DI. This can be done by plotting the two indicators on top of each other or by subtracting the +DI from the -DI. Wilder suggests buying when the +DI rises above the -DI and selling when the +DI falls below the -DI.
Wilder qualifies these simple trading rules with the "extreme point rule." This rule is designed to prevent whipsaws and reduce the number of trades. The extreme point rule requires that on the day that the +DI and -DI cross, you note the "extreme point." When the +DI rises above the -DI, the extreme price is the high price on the day the lines cross. When the +DI falls below the -DI, the extreme price is the low price on the day the lines cross.
The extreme point is then used as a trigger point at which you should implement the trade. For example, after receiving a buy signal (the +DI rose above the -DI), you should then wait until the security's price rises above the extreme point (the high price on the day that the +DI and -DI lines crossed) before buying. If the price fails to rise above the extreme point, you should continue to hold your short position.
In Wilder's book, he notes that this system works best on securities that have a high Commodity Selection Index. He says, "as a rule of thumb, the system will be profitable on commodities that have a CSI value above 25. When the CSI drops below 20, then do not use a trend-following system."
Example
The following chart shows Texaco and the +DI and -DI indicators. I drew "buy" arrows when the +DI rose above the -DI and "sell" arrows when the +DI fell below the -DI. I only labeled the significant crossings and did not label the many short-term crossings.
Calculation
The calculations of the Directional Movement system are beyond the scope of this book. Wilder's book, New Concepts In Technical Trading, gives complete step-by-step instructions on the calculation and interpretation of these indicators.
Trading Rules
In Alexander Elder's best-selling book, TRADING FOR A LIVING, he discusses his trading rules in relation to Directional System.
TRADING RULE 1
Trade only from the long side when +DI is above -DI. Trade only from the short side when -DI is above +DI. The best time to be long is when both +DI and ADX are above -DI, and ADX rises. This shows that the uptrend is getting stronger. Go long and place a protective stop below the latest minor low. The best time to be short is when -DI and ADX are above +DI and ADX rises. Go short and place a protective stop above the latest minor high.
TRADING RULE 2
When ADX declines, it shows that the market is becoming less directional. There are usually many whipsaws, just as there are turbulences in the water during the change of tide. When ADX points down, it is better not to use a trend-following method.
TRADING RULE 3
When ADX falls below both Directional lines, it identifies a flat, sleepy market. Do not use a trend-following system but start getting ready, because major trends emerge from such lulls.
TRADING RULE 4
The single best signal of the Directional system comes after ADX falls below both Directional lines. The longer it stays there, the stronger the base for the next move. When ADX rallies from below both Directional lines, it shows that the market is waking up from a lull. When the ADX rises by four steps (i.e. from 9 to 13) from its lowest point below both Directional lines, it "rings a bell" on a new trend. It shows that a new bull market or bear market is being born. Buy if +DI is on top and place a stop below the latest minor low. Sell short if -DI is on top and place a stop above the latest minor high.
TRADING RULE 5
When ADX rallies above both Directional lines, it identifies an over-heated market. When ADX turns down from above both Directional lines, it shows that the major trend has stumbled. It is a good time to take profits. If you trade multiple contracts, you definitely want to take partial profits.
Sources:
Technical Analysis from A to Z (2nd Edition) by Steven Achelis
Trading for a Living by Alexander Elder
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