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.