Trading with the Directional Movement System

A Quick Introduction

The Directional Movement System is an indicator developed by the American engineer J. Welles Wilder which identifies new potential trends in the market. It is composed of three indicators:

– The Positive Direction indicator (+DI), summarizes upward trend direction

– The Negative Direction Indicator (-DI), summarizes downward trend direction

– The Average Directional Indicator Movement Index (ADX), used to signal trend changes and to indicate whether the underlying asset is trending or ranging

*You can find the indicators’ formula at the end of the article

Signal

When you combine the three indicators together (+DI, -DI and ADX), you get the following signals:

Go long when –DI crosses +DI from below and ADX is rising and above –DI

Go short when +DI crosses –DI from below and ADX is rising and above +DI

Applications

Let’s have a look at the two charts below which show an example on how to use the DMI to trade on a currency pair.

The chart on the top represents EURUSD historical spot prices on a daily basis.

The chart on the bottom represents the three components of the DMI (+DI in blue, -DI in green and ADX in red).

DMS2

In 1, +DI crosses –DI from below, indicating that bulls have control of the market place.

ADX is above –DI, however we can see that it has been decreasing for the past couple of weeks, therefore not a good moment to start shorting EURUSD.

In 2, we can see the reversal of the ADX’s trend now starting to increase again. This indicates a long signal.

In 3, we can see that the ADX trend is losing momentum, and the trader will start to think it is time to take profit (or loss) on that trade.

In 4, -DI is crossing +DI from below indicating that bulls have control of the market place at that time. However, the ADX indicator is clearly showing a bearish momentum. Therefore, it may not be the time to go short EURUSD.

As you can see, since 5, the two Directional Lines (+DI and –DI) have been moving together and the ADX has been constantly decreasing (below the 20 threshold), indicating a ranging market and a low volatility.

Bears have control of the market place since 6, and after hitting a low of 13.6 last week, the ADX is starting to rise again. It may indicate a potential bear trend on EURUSD if the ADX keeps strengthening in the coming days.

Indicators’ formulas

We need first to calculate the Directional Movement {+DM,-DM} for today:

+DM = Today’s High – Yesterday’s High

-DM = Yesterday’s Low – Today’s low

Then, we select the maximum between +DM, -DM and zero.

Second, we calculate the True Range (TR) for the day, which is defined by the following formula:

TR = Max {Today’s High – Today’s Low, Today’s High – Yesterday’ Close, Yesterday’s close – Today’s low}

Then, we calculate the Directional Movement and the TR using the Exponential Moving Average (EMA) of 14 periods (suggestion), and we have:

+DM14 = EMA (14) of +DM

-DM14 = EMA (14) of –DM

TR14 = EMA (14) of TR

We now have the two Directional Indicators (discussed above) which are used in the Directional Movement System in order to generate signals:

+DI = +DM14 divided by TR14

-DI = -DM14 divided by TR14

The last step is to calculate the ADX, which is defined by the following formula

ADX = EMA of DX

Where DX = Abs( +DI minus –DI)

The ADX indicator doesn’t tell where the market is trending and act the same on an upward or downward trend. It is measured as a percentage scale (from 0 to 100), and usually traders put a threshold line to suggest that the trend has eventually began. The popular threshold is 40, but it is up to everyone.

Got more questions about the Directional Movement System? Contact us by email here or tweet us @LittlefishFX

 

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