Wilder’s Directional Movement Index (DMI)

The Directional Movement Index (DMI), developed by J. Welles Wilder, is a technical indicator that estimates the strength and direction of a trend. It aids in identifying whether a security is trending and how strong that trend is. Traders often use DMI to make trading decisions and to develop trading strategies.

Components of DMI

The DMI consists of three lines:

1. +DI (Positive Directional Indicator): Measures the strength of the upward movement.
2. -DI (Negative Directional Indicator): Measures the strength of the downward movement.
3. ADX (Average Directional Index): Calculates the absolute strength of the trend, regardless of direction.

+DI and -DI Calculation

To calculate +DI and -DI, you must first determine the Directional Movement (DM) for each period:

1. Calculate UpMove and DownMove:
   • UpMove = Current High - Previous High
   • DownMove = Previous Low - Current Low
2. Determine Positive and Negative Directional Movement:
   • If UpMove > DownMove and UpMove > 0: +DM = UpMove
   • If DownMove > UpMove and DownMove > 0: -DM = DownMove
   • If neither condition is met, +DM = 0 and -DM = 0
3. Calculate the True Range (TR):
   • TR is the greatest of the following:
     • Current High - Current Low
     • Absolute Value of Current High - Previous Close
     • Absolute Value of Current Low - Previous Close
4. Smoothed +DM, -DM, and TR:
   • Use a smoothing technique (commonly a 14-period average).
5. +DI and -DI:
   • +DI = (Smoothed +DM / Smoothed TR) * 100
   • -DI = (Smoothed -DM / Smoothed TR) * 100

ADX Calculation

1. Calculate the Directional Movement Index (DX):

   • DX = (

     +DI - -DI

     / (+DI + -DI)) * 100

2. Calculate ADX:
   • The ADX is the smoothed average of DX values over a specified period (commonly 14 periods).

Interpreting DMI

Crossovers

The +DI and -DI lines can be used in crossover strategies:

• Bullish Signal: When +DI crosses above -DI, it indicates a potentially bullish trend.
• Bearish Signal: When -DI crosses above +DI, it indicates a potentially bearish trend.

ADX Trend Strength

• ADX below 20: Weak or non-existent trend.
• ADX above 20: Indicates the presence of a trend.
• ADX above 40: Indicates a strong trend.

Applications in Trading Strategies

Trend Following

When ADX is above 20, traders often use the DMI for trend-following strategies:

• Enter long positions when +DI crosses above -DI if ADX is rising.
• Enter short positions when -DI crosses above +DI if ADX is rising.

Range Bound Strategies

When ADX is below 20, it may be an indication of a range-bound market. Strategies such as oscillators or mean-reversion techniques are more suitable.

Limitations of DMI

1. Lagging Indicator: The DMI relies on historical data, so it may not respond quickly to sudden price changes.
2. False Signals: In highly volatile markets, DMI can produce false signals.
3. Complexity: The calculation of DMI involves multiple steps, making it somewhat complex for beginners.

Conclusion

The Directional Movement Index is a powerful and versatile tool for assessing trend strength and direction. While it has its limitations, when combined with other indicators and sound trading principles, it can significantly enhance trading decisions.

For more detailed information on technical indicators and trading strategies, you can explore resources from financial institutions and trading platforms such as:

• Investopedia
• TradingView
• StockCharts