Why and How to Use the Directional Movement Index
Predicting the future directional movement or lack of directional movement of a stock, commodity, or forex pair has to be one of the most sought after skills when it comes to trading and investing. For decades, new and supposedly improved technical trading systems and indicators have come and gone. Some trading systems may work for a while but ultimately stop working when the market conditions change. Where most technical analysts fail is in there inability to distinguish the type of market environment they are trading in and alter their strategy. They may even go as far as throwing out a viable trading strategy when it stops working and blame their losses on the trading system and move on to something else that seems to be working right now. Many times these technical trading systems have been curve fitted to imply future increased returns while at the same time adding so many indicators to your screen it's like looking through your windshield while driving through a swarm of love bugs. You simply cannot see where you are going. Isn't this the opposite of what we're trying to do as technical analysts?
The Goal of This Article
My goal for you with this article is to become a better technical analyst by reducing the number of indicators on your screen and get you focused on predicting future price direction (or lack thereof) in stocks, commodities, and currencies. We're going to accomplish this by revisiting the Directional Movement Index published by J. Welles Wilder in his legendary 1978 book, New Concepts in Technical Trading Systems. After we establish the basic premise of what Wilder taught in his book, I'm going to give you some modern techniques using the same technical information form Wilder's Directional Movement Index or DMI.
Let's Start With a Plain Price Chart
Before we get into the DMI let's start with a naked price chart with no indicators, volume, or moving averages. What you're seeing in the chart of BAC below is pure price with a Japanese candlestick chart. We can see that the price continues to move up during this time period for the stock. We can safely say without any kind of indicator that Bank of America is in an uptrend. And by uptrend I mean that price is moving up over the specified time frame. In this example, it's about two months.
But as you'll also notice I'm sure, that the price doesn't move up each and every day. Inside this apparent uptrend, there are smaller incremental moves. Some are sideways and some are pullbacks. At Point 1 on the chart, the stock is coming off a 2 day sell off and starts to move higher. The uptrend stays intact for a couple weeks and starts to trade sideways or consolidate around Point 2. The stock then breaks out of it's sideways move to the upside only to sell off hard 3 days in a row at Point 3. This sell off took price below Point 2 which would have many to believe the uptrend is over. But miraculously the stock recovers and moves to new highs. Then it pulls back and finds buyers at Point 4. Before the stock makes new highs again, there is a small consolidation at Point 5. After several up days, profit taking seems to kick in and a pullback gets started at Point 6.
So now that we've examined this obvious uptrend a little we've found a lot of smaller movements inside of the move. One thing I'd like to point out now though is that the only reason we can call this an uptrend is because of the power of hindsight. The reality of this and any trading instrument is what has been termed the Hard Right Edge. When you look at the pullback at Point 6 in the chart of BAC, we now have no clue where price is headed next. This is the bind we find ourselves in each and every day. The Hard Right Edge of the chart is where we live.
Let's take a second to go through the chart above again but this time, pretend we do not know where price is heading and imagine some of the questions we would have had to answer along the way. Is the selloff really over at Point 1? Would you have bought the bull flag breakout at Point 2? Would you have been stopped out at the failed breakout or even gone short at Point 3? Would you have bought a pullback to support at Point 4 even though the gap up was never filled? After the recent choppiness would you have been positioned for the breakout at Point 5? If so, where will you take profits, at Point 6?
As you can see, the hard right edge of the chart is a difficult place when trying to profit from the directional movement of a stock, commodity, or currency.
As Wilder wrote in his book, "Directional movement is the most fascinating concept I have studied. Defining it is a little like chasing a rainbow... you can see it, you know it's there, but the closer you get to it the more elusive it becomes."
So imagine the possibilities of being able to measure the rate of the directional movement of any stock, commodity, or currency. If you're using a trend following system, you would only want to trade charts in an uptrend similar to the Bank of America example. If you are using a range bound trading system, you would only want to trade charts showing a lack of directional movement. This brings me back to my initial point of being able to determine the current market conditions and then apply the proper trading system.
Wilder's Directional Movement Index
So let's start with the two main parts of Wilder's Directional Movement Index (DMI) which are the Plus Directional Movement Indicator (+DI) and the Minus Directional Movement Indicator (-DI). These two indicators are the foundation of the popular Average Directional Index (ADX). The ADX is used to provide information about the strength of a trend but not its direction. The +DI and -DI give information about the positive and or negative direction of price movement over a period of time.
In Wilder's book, New Concepts in Technical Trading Systems, the complete information about the theory and math of these indicators that make up the Directional Movement Index is given and I recommend picking up a copy if you'd like more information of the original system and methodology. Let's cover the basics here though. The Plus and Minus parts of the DMI focus on that portion of the current candlestick's trading range that is outside the range of the previous candlestick. If it is higher, then it considered positive. If it is lower, then it is considered negative. These values are then divided by the true range and then averaged over time, usually 10 or 14 periods. When the +DI crosses above the -DI, it implies that positive or upward price direction has overtaken negative or downward price direction. The opposite is true when the -DI crosses above the +DI. In this case, selling pressure or lack of buying pressure is taking control.
These two indicators are going to tell us some basic information on the chart about the strength of directional moves. I like to refer to this as buying pressure and selling pressure. On any given day, there are investors buying and selling a given stock. The +DI and -DI lines are going to tell us the strength of both the buyers and sellers so that we can determine whose winning the battle of the bulls and bears.
But what determines the positive or negative movement? Let's take minute to cover how the +DI and -DI are calculated. When a certain period’s high exceeds the high of the previous period, we have positive directional movement. If however the day’s low is less than the previous day’s low, we have negative directional movement. If the latest period’s range is completely engulfed by the previous one, it is ignored. In the opposite scenario, when the latest day’s range completely engulfs the previous ones, the greater difference wins. All these four cases are illustrated below.
Adding the DMI To The Chart
Now that we have most of the math out of the way, let's see this in action. Let's take a look at the same chart of BAC above and add the Directional Movement Index. For this example, I removed the ADX line so we can just focus on the +DI and -DI lines for now.
Remember, the DMI focuses the part of today's range that is trading outside of yesterday's range. When the stock is making new highs, the green +DI line will move up. Typically the lows of the candlesticks also increase telling us the bears are losing the battle. This in turn causes the red -DI line to decrease at the same time.
Starting on the left of the chart, we can see two red candles before the reversal at Point 1. When we look at the DMI, the red -DI line is trading above and is decrease indicating that the bears were previously on top and are now losing. After a few days the +DI and -DI lines meet at Point 7. The lines tangle a bit but the stock marches higher causing the DMI lines to move away from each other. And since the bulls are winning at this point, the +DI green line moves higher and the -DI red line moves lower.
During the small consolidation at Point 2, we can see the DMI lines start to move together slightly as new highs and lows aren't really being made as the stock trades sideways. As the stock moves higher it sells off for a few days into Point 3. Now even though the price level at Point 3 is lower than Point 2, the DMI lines are near the same level. This converging of the +DI and -DI lines means there is an equilibrium of buying pressure and selling pressure. Another way to say this is that when the +DI and -DI lines meet, it can often be support or resistance. Many times it is a better level of support and resistance as a price level itself.
Moving on we see some consolidation at Point 5. Some may see this as a double top or a resistance level because the last time the stock traded around the $15 level a few days before Point 4, the stock sold off. But at Point 5, the DMI is telling us something different. Given that the +DI is well above the -DI it is clear the bulls are in control in which the stock was able to break out and rally for a couple weeks into Point 6. Hopefully you can start to see this chart through a different lens giving you clues as to the future directional movement of the stock.
What We've Covered So Far
So let's summarize a few takeaways from what we just went over:
1. When a stock is making new highs, the +DI green line will increase.
2. When today's low is higher than yesterday's low, the -DI red line will decrease.
3. When a stock is making new lows, the -DI red line will increase.
4. When today's high is lower than yesterday's high, the +DI green line will decrease.
5. In a typical rally, the +DI line will be on top of and moving away from the -DI line.
6. In a typical decline, the -DI line will be on top of and moving away from the +DI.
7. After a strong move in either direction, a pullback will cause the lines to move back towards each other.
8. As the +DI and -DI lines start to converge, support and resistance is often found when the lines meet or even cross.
The next part of the Directional Movement Index is the ADX in which Wilder details in his book. The ADX is used to provide information about the strength of a trend but not its direction. In this article, I'm not going to cover the ADX but I do want to continue with the discussion on the +DI and -DI lines and the emphasis Wilder placed on them
As he states, "True Directional Movement is the Difference Between the +DI and -DI lines." And by difference he means the literal difference or the subtraction of the higher value line minus the lower value line depending on the trend. Each day we are adding to the +DI, we are subtracting from the - DI. If a stock rallied for 10 straight days the +DI would have a large value and the -DI would have a small value. The difference in these values would be a large number.
The opposite is true too. If a stock sold off for 10 days in a row, the -DI would have a large value while at the same time the +DI would have a small value. Again, the difference in these values would be a large number.
In the situation where a stock, commodity, or currency was choppy around, the +DI and -DI lines would be in and around the same value. You would then end up with a small value when subtracting the values of the two lines.
So in short, if the Difference in the +DI and -DI is a large value, the stock is exhibiting a lot of Directional Movement. If the Difference in the +DI and -DI lines is small, the stock is exhibiting a lack of directional movement.
Now that we have a better understanding what the +DI and -DI lines are telling us, trading with them in their raw form isn't exactly easy.
Making It Easier To See
In the chart of QQQ, you can see the +DI (green) and -DI (red) displayed in the bottom pane as lines that often cross and crisscross above and below each other. I've found the crisscross action of these lines to put out a lot of noise making it difficult trade with. To help reduce the noise, I prefer the DMI_Oscillator which is shown just below the price bars. The DMI_Oscillator is formed by subtracting the -DI value from the +DI value and then plotted as a histogram. The resulting oscillator crosses above and below a zero line. This is what Wilder was saying the real breakthrough is, the difference in the +DI and -DI values.
When using the DMI_Oscillator, the zero line represents the crisscross of the +DI and -DI lines. There is no difference in the actual numerical values of the two indicators. It's simply a different way of seeing the same information. I prefer using the histogram because it reduces some of the noise seen in the zig zagging lines. This makes it easier to avoid fake outs in price direction. It also gives a clearer view of price momentum in both directions.
The look back period I'm using in the QQQ chart is 10 bars. The default for some platforms may be 14 as the original +DI and -DI used 14 bars. Also, you'll notice that the price bars look slightly different. This is because when the DMI_Oscillator is trading above zero, the price bars are green. As the oscillator crosses below the zero line, the price bars turn red. By coloring the price bars as they relate to the position of the DMI_Oscillator and its zero line, the chart itself can help display price direction and periods of consolidation.
Your Next Move
I hope you found this article helpful and encourage you to take another look at this powerful yet simple indicator for predicting future price movement of stocks, commodities, and currencies. I'd also love to hear from you in the comment section below.
Additionally, I've got a great video from a previous trading course of mine called Trading with the DMI Oscillator for those who'd like to explore this indicator further. The video is about 30 minutes and goes into extreme detail.
In the video I'll cover:
1. How to find support and resistance using the DMI Oscillator (More powerful than simple price levels)
2. The DMI reversal zone. (Identify highly probable reversal levels for buying pullbacks and shorting rallies)
3. Bullish and bearish divergences. (Yes, the DMI Oscillator does this too)
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