DMI (Directional Movement Indicator)

Introduction

In the massive world that is the stock trading realm you’ll come across every type of trader imaginable with each of them having their own visions of what they want to do. Because of that whether it’s following trends or searching for crossover or divergences chances are there’s an indicator out there that can do all of that.

But what kind of indicators are we talking about here? The first things that you’ll likely come across would be those moving averages and there are many of them including DEMA, WMA, EMA, and SMA. However here we won’t be looking at either of those. Our attention will instead be directed towards the DMI indicator or the Directional Movement Index.

What is DMI (Directional Movement Indicator)?

The DMI was initially created back in the 1970s and J. Welles Wilder is its founder. But what does it even do you might ask? It just compares earlier highs or lows and presents you with two lines and these are the positive and negative directional movement lines, aka the -DI and the +DI. You have a third line too and that’s called the ADX.

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The Purpose of DMI

The main point of why the DMI was even made was to identify which direction the price is trending towards and how strong that trend can be so that’s what all those lines are there for. But how do they exactly do that? So if you see the +DI line over the -DI one then the price basically has more upward momentum or pressure than downward.

But if the -DI is over the +DI it means there’s more downward pressure on the price. This is how traders can then assess trend direction and they could also use those crossovers between those lines as signals for whether they should buy or sell.

How is DMI Calculated?

You wont really need to calculate the DMI values yourself since every trading platform that supports it will calculate those for you but it wont hurt to have a little insight into what goes into those calculations which is what we’ll be looking at below.

DMI Calculation Steps

We’ll start off with the formulas first which there are three of:

+DI = (Smoothed +DM/ATR) x 100

-DI = (Smoothed -DM/ATR) x 100

DX = (+DI – -DI/+DI + -DI) x 100

The DM in the formula is basically directional movement whereas the ATR stands for  average true range

There are many  steps that go into calculating the DMI but for brevitys sake we’ll mention the main ones which boil down to six

So that first step is you calculating the true range and both the negative directional movement and the positive directional movement for every period. Typically 14 periods are used and then the second step would be to smooth out those 14-period averages of TR and +DM and -DM.

The third step would be to calculate the -DI and +DI. Then you’ll need to calculate the directional index and find the smoothed average for that to get the ADX. Finally just plot the ADX, +DI and -DI now and you have your DMI now.

Key Characteristics of DMI

The key characteristics of the DMI  would have to be the positive and negative directional movements the average directional movement index or the ADX, and the average true range.

How to Use DMI in Trading

By now you must have had a fair idea of what the indicator is about so you might be more curious about how you can actually use it within your trading activities. Well that’s what this section will cover.

Identifying Trends with DMI

One of the more obvious use cases for the indicator is trend confirmation or identification. But how can you do that. If you see the +DI well over the -DI, the trend has more strength towards the upside and this will help to validate existing long trades or newer long trade signals depending on the entry methods. On the other hand, if you see -DI substantially over the +DI line then you have a confirmation of a strong downtrend or short positions.

DMI Crossovers

Then you have crossovers as well and these tend to be treated as a main trading signal. You can take long trades if you see the +DI line crossing -DI line as the chances of an uptrend being underway are there. At the same time youd want to sell when you see the +DI moving under the -DI, as a downtrend could be on the way and you don’t want to have the short end of the stick when that happens.

DMI and ADX for Trend Confirmation

But what about ADX and where does that fit in all this? Well to start with the ADX is typically plotted as a single line where values range from zero to 100. ADX is non-directional in that it just registers the strength of the trend itself and sees whether prices are going up and down. You will see it alongside those DMI lines which the ADX is derived from.

So what can you take from all this? If the +DMI or +DI line is over the negative DMI prices will be moving up and ADX thus measures that uptrend’s strength. But if the negative is below the positive DMI prices will be going down so ADX will then measure the strength of that downtrend basically.

DMI Strategies for Different Trading Styles

But how can a day trader, a swing trader, or even a long-term trader start to use this indicator in relation to their trading styles you might be wondering. There are a couple of things that each one of them could try so let’s get into that then.

Day Trading with DMI

If you’re a day trader then that means you’re more interested in those short term gains than anything. So what you can do with the DMI is to just adjust the periods according to your requirements and start from there. Strategies like trend confirmation and scalping may be something you could look into.

Swing Trading with DMI

However if it’s swing trading that you find appealing then that implies you’re looking into medium to long term gains. Because of that you could change those time frames to better reflect that and can use strategies that involve crossovers or divergences.

Long-Term Investing with DMI

Still what if it’s the long term that you find more interesting? Easy, just start by increasing those time frames so that you have a longer look back period. Then you could use the ADX to confirm the strength of existing trends so that you know what you’re getting into with your trades.

Advantages and Limitations of DMI

Knowing your way around this indicator means knowing both the positives and the negatives. If you know that then that means that you can make the most out of your trading and not be that negatively impacted by its limitations.

Benefits of Using DMI

Starting with those benefits the indicator can be a good trading tool for confirming the strength of trends as well as identifying them. Because of that you can even have some decent trading signals and that’s always a welcome feature. Other than that, it’s flexible in that it can cater to various trading styles too.

Limitations of DMI

The DMI indicator even if it’s used with the ADX it can still be prone to generating false signals. So yes you better be wary of that and come up with countermeasures to avoid it. How it can produce those false signals can vary too. For example you could have a crossover with the price not responding.

Conclusion

The DMI can be a helpful indicator to incorporate in those trading goals of yours

You can use it as a way to know when you’re going to enter or exit a trade, understand how strong current trends are and you could even combine it with other indicators to improve that accuracy which could always be improved upon

It’s because of that that the DMI is often an indispensable tool for a lot of traders who just want to make more informed decisions

Still, that doesn’t mean that one can just gloss over those cons. Knowing those should always be a priority as like we alluded to earlier the indicator cannot be relied fully upon each and every single time. There will be moments when it may not function as you intended or when it gives you a false signal. You need to be prepared for that if it does happen.