Tips on Technicals - Directional Movement System
| Indicator type: |
Trend finder |
| Used to: |
Identify direction and strength of a trend |
| Markets: |
All cash and futures, not options |
| Works Best: |
All markets and time frames |
| Formula: |
Calculate the Positive Directional and Negative Directional Movement Indices. (See Directional Movement Index chapter.) |
| Parameters: |
The "n" value in the DMI calculation corresponds to trader preference in RSI, Stochastics and other Welles Wilder studies. Daily charts use values of 9 to 14 with 10 being Wilder's original. |
| Theory: |
Most technical tools used today fall into one of two categories, oscillators and trend followers. RSI and Stochastics are examples of the former and moving averages and bands are examples of the latter. However, not all studies are effective in the different types of markets. Trend following studies often cause false signals, and hence losses, in flat or erratic markets. Welles Wilder has developed a system to determine whether the market is in a trending mode and if so, how strong that trend is. |
| Interpretation: |
This system can be used as a filter for more traditional studies. If DMIA is above 25-30, a trend following system can be used. If it is below 25-30 then an alternate should be used. Buy when PDM crosses above MDM and sell when the reverse occurs. When PDM is greater than MDM it means days when the trend was up outweigh the days when the trend was down (over the past "n" days). The greater the difference, the stronger the trend.
The next step in using the system is to calculate the difference between the two lines, called DMI, and plot it separately. The Directional Movement System uses a moving average of the DMI called either DMIA or ADX. This allows for one number to measure the strength of the trend. Note that this is not a simple spread calculation but rather a percentage measure of net directional movement. |
Above is 200 days of the NYMEX Natural Gas Continuous futures with a 20-day Directional Movement System and 40-day moving average. During early March, the contract was in a triangle-like pattern with MDM (-DM) still holding above PDM (+DM). This would be bearish except for the fact that the DMIA (ADX) was heading lower. In early April, PDM crossed above MDM but DMIA had not yet turned higher. When it did finally rise, the market had already broken higher from the triangle. However, this signaled that trend following systems were now valuable as the market had moved into a trending mode.
In May, DMIA flattened and headed lower and this lead the choppy trading period of June-July by a few weeks. As can be seen, the simple moving average crossover system was whipsawed several times. Finally, when the market broke above a small declining trendline (not drawn), PDM crossed back above MDM and DMIA moved sharply higher, a trending mode was reestablished.
New positions are initiated when the DMIA line crosses above both +DM and -DM and the DMIA is rising. In the chart above, after exiting the short position in April, no new positions were initiated until September when a new short was indicated by DMIA rising. This trade lasted for only a few days as DMIA once again reversed.
