This Indicator Helps Gauge Conviction Between Bulls And Bears
The Directional Movement Index (DMI) is a required input for the Average Directional Index (ADX) indicator. (This is a popular indicator we covered in this article.)
The Positive Directional Index (+DI) and the Negative Direction Index (-DI) are found separately and then used to calculate ADX. Or the two indicators can be used as a standalone trading strategy.
Some websites and trading software will use different terms to describe these indicators. DMI plus is sometimes used for +DI and DMI minus may be used for –DI. The calculation and interpretation is the same no matter what they are called.
What is Directional Movement Index (DMI)?
Calculating DMI involves many steps. The indicators can easily be found from a variety of sources. In general terms, DMI is positive when the difference between today’s high and yesterday’s high is greater than the difference between the two lows. It is negative when the difference between the lows exceeds the difference between the highs.
These tools were introduced in J. Welles Wilder’s 1978 book, New Concepts in Technical Trading Systems. Wilder pioneered many technical indicators that are still in use today (other tools from Wilder include RSI, ADX, and ATR, to name a few). In this case, Wilder was trying to identify whether bulls or bears had more conviction. He used the size of the trading range as evidence of that. He assumed the larger move represented the direction of the trend.
These moves are tracked for the last 14 days and summed together. If DMI is positive for a day, then –DI is equal to zero. On days when DMI is negative, +DI will be zero. This may be a confusing process at times, but the indicators can easily be found at many websites or in any trading software.
How Traders Use Directional Movement Index (DMI)
As mentioned, values for DMI are needed to calculate ADX. But they can also be charted separately and used as a trading strategy, which we have shown in the chart below.
This chart below shows the price action of the iShares Silver Trust (NYSE: SLV) over a two-year period. Traders would be long when +DI (green) is greater than –DI (red).
Several trading opportunities are shown in the chart, most notably from March through late September of 2020. This included a period where SLV ran from about $14 all the way up to $27. But by the time the red crosses over (the sell signal), SLV fell back to $22.
Also, there are many times when the two indicators rapidly cross each other. This would lead to a large number of small trades. To avoid that, traders can apply a trend filter like ADX, which we have also included in the bottom panel. Signals would then only be taken, for example, when ADX is above 25 (which would indicate that a market is trending).
Why Directional Movement Index (DMI) Matters To Traders
DMI offers traders a simple and logical trading strategy, which traders can use for a clearly defined rules-based system of trading.
Although the rules are clear and easy to interpret, the system does suffer from the problem of an excessive number of crossover signals at times. This is where it’s important to emphasize that it’s wise to not rely on one indicator alone. However, combined with other trading tools, like ADX or moving averages, DMI can provide valuable input in a trading system.
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