Traders Toolbox: How to use the Directional Movement Index
The Directional Movement Index, commonly called the DMI, is a powerful trend-following indicator. Many false signals generated by indicators such as the stochastics are filtered out by the DMI. Subsequently, this trading and analytical tool gives few signals, but, when generated, they tend to be very reliable.
Many, who at first glance are strangers to the DMI, find they are familiar with the prime component of the index: The ADX or average directional movement index. This discussion will center on the main use of the ADX, the turning point concept.
The DMI consists of three components: The + DI, which represents upward directional movement; the - DI, indicating downward movement; and the ADX, which signifies the average directional movement within a market.
In STRONG UPTRENDING moves, such as the late 1989 and early 1990 rally in the CRB, the + DI and the ADX turn up early in the move and move higher, with the + DI generally holding above the ADX. A high probability signal the uptrend has stalled or ended is generated when the ADX crosses above the +DI and turns down. This signal commonly occurs on the trading period of the trend change or slightly before. It rarely takes more than a few periods past a true trend shift to see the ADX turn down.
The rules for signalling a potential bottom are the same as for a top: Simply substitute the - DI for the + DI. There appears to be one slight difference between tops and bottoms: Generally, the ADX turns from a higher level when marking a top.
Several chart services plot only the ADX. In these instances, it can generally be assumed that a downturn in the ADX which occurs after crossing above 40 will have seen the ADX cross above the + DI if the market had been in an uptrend and above the -DI if in a downtrend. In simple terms, a move by the ADX above 40 followed by a downturn generally signals a probable trend change.
Signals such as those which occurred in May, 1990 and February, 1991 in the CRB index (arrows) can be very valuable in confirming a turn which had been projected by unrelated methods of technical analysis. ADX signals can help confirm the expected completion of a wave structure or to underscore a turn within a critical time period.
The DMI is based on a certain number of periods. I have had the most success with 14 days on daily charts. And with the exception of Treasury Bonds, for which I use 14 weeks, I prefer to use 9 periods on the weekly and monthly charts.
Editors note: While the examples shown are somewhat dated the concept and use of the ADX is not. The ADX indicator is available on MarketClub.
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6 Responses to “Traders Toolbox: How to use the Directional Movement Index”
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The most extensive discussion on the ADX (ADXcellence - Power Trend Strategies) is a book by Charles Schaap. He uses 13/8 by the way. The book is very expensive, but it does handle the topic in 272 pages.
If the trend is really in place, the ADX and its components +DI and -DI give a heads up. Like everything else in investing, nothing is perfect and stop loss is the mantra.
Thank You For a Very Good Post.
Bear in mind that increasing the number of periods will smooth the ADX line (making it less volatile), and display more significant readings. The readings, however, will present more of a lag. For example, if charting 30 periods, readings over 40 become stronger indicators of a trend. However, the trend may have already started and could have been caught earlier less periods were used.
almost every experience trader suggest ADX as a confirmation indicator when i read their blog.
i’m myself using ADX as a confirmation signal to other indicator signal especially during the initial Swing trade. So far so good.
Combine it with convergence/divergence method, its almost perfect indicator. The problemm is do we really understand what ADX telling us….
Please just teach me how to set stops wide enough to make the most of a trend. I know through the triangles what the probable trend is, however because the market moves in jagged edges even knowing the trend doesn’t help if stops are garbage.
What’s frustrating is that you know the direction of the train and that you want to be on it but you just keep missing it and losing money. Makes you feel so dumb giving money away yet you’re doing the right thing.
Some course say go with tight stops and others set them real wide - somehow I’m missing the point, if the triangles are a reliable system that has a high probability of success then doesn’t it make sense to have faith in your system and set wide stops.
That is - stops outside the trend line of the signal chart. I guess that would be the weekly chart if the trend is determined by the weekly.
Cheers
Trend Master Series, also by Dr. Schaap teaches everything you need to know about setting stops. In a trend or swing trade, he gives specific rules, I have found it invaluable.