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Directional Movement System (Wilder)

Please note that we have used historical data. These examples are for educational purposes only.

In this issue of the ChartFilter newsletter we'll look at Wilder's Directional Movement system, incorporating three indicators - Directional Movement Index (DMI), the Average Directional Index (ADX), and Parabolic SAR.

The DMI system is an effective and frequently used trend indicator. This system was designed by Welles Wilder Jr. and is made up of three lines:

  1. The +DI indicates the up average.
  2. The -DI indicates the down average.
  3. The ADX, average directional movement index, shows whether a trend is in effect by smoothing the difference between the +DI and -DI.

CURRENT TRENDS - Learning from the Indices

In this section we'll apply the DMI system to the NASDAQ and DJIA indices. Since DMI is a trend indicator it can provides some useful insights into possible changes in trend. The current short term trend for both the Dow and the NASDAQ is downwards. However there are some signs being given by DMI that this may be changing... let's take a look at the charts.

I've charted both the NASDAQ and DJIA and drawn trendlines. Both charts also feature the DMI, ADX and Parabolic SAR indicators. I've used a six month daily chart in the case of the NASDAQ, and a one year daily chart for the DJIA.

With DMI/ADX I look for a couple of signals:

  1. when ADX is above 20 it indicates that the underlying stock or index is trending strongly enough to make a move in one direction or the other. (ADX is an indicator of the strength of a trend, not the direction!) As a simple rule of thumb, I wouldn't consider buying a stock when the ADX is below 20 (unless there are very strong overriding circumstances or I'm interested in a long term trade and several other indicators are bullish).
  2. where is the +DMI line relative to the -DMI line? +DMI should be above -DMI. A bullish signal is given when +DMI crosses above -DMI, particularly when ADX is above 20.

Now combine this with Parabolic SAR - with this indicator you have a bullish signal when the parabolic dots switch from above the price line to below.

Let's consider the above chart for NASDAQ:

  1. Parabolic SAR switched (gave a bullish signal) relatively recently in early December.
  2. ADX is above 20 at roughly 35 or so (bullish). However, it is downtrending, which is not as favourable as an uptrending ADX. 3.
  3. +DMI is below -DMI - and therefore not yet bullish. Consider this a caution.

You can see the value of the DMI system above, when you consider that +DMI (blue) dropped below -DMI (red) in July and has basically remained there ever since (other than a brief foray above in early September).

Now let's take a look at the Dow Jones Industrial Average. (Remember this is a one year chart, compared to the six month chart above).

Here's what the indicators are telling us:

  1. Parabolic SAR has recently switched from above the line to below - once again a bullish signal.
  2. +DMI (blue) has also recently crossed above -DMI (red) - another bullish signal.
  3. However, ADX (black) is below 20. Consider this a caution.

Once again we have a couple of bullish signals, however with cautions in both cases. So we have the early signs of a possible switch in short term trend for both the NASDAQ and the Dow. Keep an eye on these indicators in the coming days, if the cautions are removed, we could have the early signs of a trend reversal. Remember to consider also the trendlines - a further bullish signal will be given when the top resistance trendline is broken on the upside.

In addition, please note the value of ADX in the DJIA chart above. See how valuable it can be in keeping traders out of choppy waters? ADX dropped below 30 and then 20 in April. This was the beginning of a very choppy sideways market for about 4 months. As we've seen in the past, these choppy markets are very difficult to trade successfully. In this case ADX would have done its job by keeping you on the sidelines. When ADX broke above 20 in August, we began to see more strongly trending markets with more significant moves. Once again, let me remind you that ADX signals the strength of the trend - the direction of ADX is not related to the direction of the underlying market. If you have an uptrending ADX line, it is telling you that the market trend is picking up strength - the market itself may be headed downwards or upwards.

And here's one more quick tip - when ADX is above 20 or 25 and +DMI is above -DMI you can ignore sell signals given by the Parabolic SAR (when the dots switch from below the price to above).