The Directional Movement Index [DMI] indicator is one of the more popular indicators used by technical traders. This indicator has two componentsâthe first being the DI lines and the second the ADX line. The DMI and ADX indicators are plotted in the same area underneath the price chart. The DMI indicator can be used to trade directionally where as the ADX indicator confirms whether a trend is present. In this article I will explain the two components of the DMI indicator and how these can be used to form a directional bias on a security. You will also be able to rate the strength of the trend. Welles Wilder is the founder of both the DMI and ADX indicators.
Average Directional Index [ADX]
The ADX is used to identify how strong the current trend is in a security. The ADX is a normalised index which means it ranges between 0 and 100. This indicator very rarely shows extreme readings. When the ADX crosses above 20 it is a signal that a trend is developing. Conversely, when the indicator crosses below 40 it's a sign the most recent trend is losing strength. The direction of the ADX indicator does not indicate whether the security is bullish or bearish, rather, it answers the following two questions-
1. Is there a trend in place?
2. Is the trend gaining or losing momentum?
Chart 1 below shows a bullish run during late 2006 and early 2007.
Chart 1 â IBM Daily Bar Chart
+DI and -DI
The (+DI) and (-DI) components in the DMI indicator can be used for directional trading. When the +DI crosses above the âDI this is a bullish trigger whilst the âDI crossing above the +DI is a bearish trigger. These crossovers when used in conjunction with a high reading on the ADX indicator can provide good entry points for a strong trending market.
Chart 2 â SPX Daily Bar Chart
As a trader there are so many technical indicators available to you. What is imperative is that you understand how to interpret the indicator. The best way to do this is by reading books/articles on how the indicator is constructed. Once you have a good understanding, the next step is to paper trade the indicator and test to see if it can aid your trading by increasing the profits.