Understanding Directional Movement Index in Trading

Most people hesitate to make a trade in the stock market because they lack the knowledge of technical analysis and patterns. If you want to determine whether a stock is moving up or down, the Directional Movement Index (DMI) is one of the primary tools you can use.

Created by J. Welles Wilder in 1978, the DMI determines the direction of an asset’s price movement. Read this blog to understand what is directional movement indicator and how it works.

What Does Directional Movement Index (DMI) Mean?

A directional movement index is an indicator that helps in identifying the direction and strength of an asset’s price movement. It draws lines of positive directional movement (+DI) and negative directional movement (-DI) by comparing the current price with previous lows and highs.

Price pressure that is more upward when +DI is larger than -DI indicates a buying signal, whilst price pressure that is more downward when -DI is higher indicates a selling signal.

The directional movement indicator also includes the Average Directional Index (ADX), an extra line that shows the intensity of an upward or downward trend.

How Does Directional Movement Index (DMI) Work?

The high and rising levels of ADX and ADXR indicate strong trends, either up or down. This suggests that a trend-following system would be useful. ADX often signals a strong trend if it is above 25.

Additionally, a price pressure that is more upward when +DI is larger than -DI indicates a buying signal. Conversely, price pressure is more downward when the DI is higher, indicating a selling signal.

The DMI also includes the Average Directional Index (ADX), an extra line that shows the intensity of an upward or downward trend.

Key Features of Directional Movement Index (DMI)

You can learn a lot from a directional movement index by knowing its key components. Here are the features of DMI you should know about:

1. Positive Directional Indicator

   It shows the difference between today’s high price and yesterday’s high price. After adding together these data over the previous 14 periods, they are plotted.

2. Negative Directional Indicator

   A negative directional indicator, or -DMI shows a gap between today’s low price and yesterday’s low price. After that, these numbers are summed up over the previous 14 periods and shown.

3. ADX

   The ADX smoothens the DX.

4. The Average Directional Movement Index Rating

   The Average Directional Movement Index Rating (ADXR) is a straightforward average of the ADX value from 14 periods ago and the ADX value from now.

How to Calculate Directional Movement Index (DMI)?

The directional movement index calculates the price movement strength. You can also involve the +DI and -DI indicators, which show upward and downward trends. The DMI calculation can be split into two steps. ADX should be computed after +DI and -DI.

To calculate +DI & -DI, you must ascertain +DM & -DM (Directional Movement). You can calculate +DM & -DM using the high, low, and close for each period. Next, you can calculate the following:

Upward Move = Current High – Previous High

Downward Move = Previous Low – Current Low

+DM = Upward Move if upward move is greater than downward move and upward move is greater than 0, otherwise +DM is 0.

-DM = downward move if downward move is greater than upward move and downward move is greater than 0, otherwise -DM is 0.

Once you get the current +DM and -DM, you can calculate and plot +DM and -DM lines depending on the number of user-defined periods.

+DI = 100 x Mean True Range / Exponential Moving Average of (+DM)

-DI = 100 x exponential moving average of (-DM / ATR).

After calculating -+DX and -DX, the final step is to calculate the ADX.

ADX = 100 x Absolute Value of (+DI – -DI) / (+DI + -DI) Exponential Moving Average.

Example of DMI

To understand what is directional movement index more easily, consider this example. In this example, Microsoft Corporation’s stock DMI (MSFT) is utilised. Historical testing was conducted between February 27, 2023, and February 26, 2024.

The purchasing condition is met when +DI exceeds -DI. This would eliminate any short positions. Conversely, A +DI crossing below -DI indicates a sell position. In this situation, any long holdings will terminate.

The following are some DMI trading strategy hypotheses:

1. Initial investment of USD 1 million
2. Equity order size of 100%
3. No pyramiding order
4. No trades leveraged
5. Commissions and taxes slippage are disregarded
6. Time period of 14 days

The outcomes are:

1. Net income of 6.95%,
2. A total of 11 closed trades
3. 45.45% of profitable trades
4. Generated profit of 1.602
5. Maximum reduction of 9.47%
6. obtained or retained for the same duration, or 22.81%

Benefits of Using the Directional Movement Index (DMI)

Here are the benefits you can avail while using the directional movement index:

1. DMI helps determine the direction and strength of a trend in an asset’s price movement.
2. When +DI is higher than -DI, indicating a buying signal, the price is under more pressure to rise. When DI is higher, which indicates a selling signal, the price is under more pressure to fall.
3. DMI helps identify trend direction and provides trading indicators.
4. DMI shows trend direction evaluation and trading signal generation.
5. Crossover is the main trading indication. Long trades are made when +DI crosses above -DI and an uptrend seems to be beginning. On the other hand, when +DI crosses below -DI, a sell signal is produced.

Limitations of Using the Directional Movement Index (DMI)

While there are a lot of benefits, the directional movement index also has some limitations.

1. You can add the DMI trend direction to ADX strength values.
2. An ADX rating of 20 or above indicates a strong price trend. Whether or not you use ADX, the indicator is still prone to producing false indications.
3. Interestingly, crossovers and +DI and -DI readings depend on historical pricing and might not be a reliable indicator of future developments. There may be a crossing, but the price may not respond, resulting in a loss of money.
4. Lines may also overlap, which results in several indicators but no obvious price trend. You can prevent this by using ADX readings to help identify strong trends or by only making trades in the direction of broader trends according to long-term price charts.

Final Thought

A directional movement index is a helpful technical analysis tool for figuring out the direction and strength of a price trend. The two primary components of the indicator are +DI and -DI, as well as ADX, which measures trend strength.

The first step in calculating DMI is determining the direction of price changes by comparing subsequent highs and lows. After that, these differences are smoothed over a certain period of time to identify the trend direction.

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Frequently Asked Questions

1. Is directional movement index (DMI) a leading indicator?

You can consider the directional movement index as one of the leading indicators, as it is a useful instrument for evaluating stock movements. This indicator can offer important insight into market movements because equities typically only trend 30% of the time.

2. How to utilise the directional movement index (DMI) indicator?

The directional movement index provides trading indications and aids in determining the direction of the trend. A long trade can be made if the +DI line is higher than the -DI line. This indicates that the market can go upward. Similarly, people make a short trade because they think the market can go downward if the -DI line is higher than the +DI line.

3. What time is best for using the directional movement index indicator?

You can use the directional movement index, usually daily, weekly, or monthly charts. These time periods offer a decent compromise between identifying patterns.

4. How do you interpret the directional movement index indicator?

Interpreting the DMI is easy. Price pressure that is stronger when +DI is higher than -DI, indicates a purchasing signal. A higher -DI shows a selling signal. The DMI offers trading indications and aids in determining the direction of the trend.

5. How is the DMI different from an ADX indicator?

The function of both these indicators makes them different. While ADX measures a trend’s strength regardless of its direction, DMI gives the direction.