|The Directional Movement Index (DMI, ADX)|
The Directional Movement Index (DMI, ADX)
Please note that we have used historical data. These examples are for educational purposes only.
This month we'll focus on the use of Welles Wilder Jr.'s Directional Movement system of indicators. The DMI system is an effective and frequently used trend indicator. DMI stands for Directional Movement Index, and ADX is the Average Directional Movement Index.
This system is well worth investigating. It can be complex, but it doesn't have to be! The calculations are complicated, but now that computers crunch the numbers we can focus on interpreting the results.
So don't let DMI and ADX intimidate you! Follow along and you'll probably find the potential for this indicator very interesting.
CURRENT TRENDS - Learning from the Oil Index
Gas and oil prices are skyrocketing. Truckers are protesting throughout Europe. Maybe it's time to kick the oil habit anyway and move as quickly as possible to cleaner, more sustainable sources of energy... solar, wind, tides, small-scale hydroelectric... there are lots of choices.
Meanwhile, there's money to be made in oil, and it's just a matter of investing in oil stocks or funds at the right time. Based on the AMEX Oil Index we could have profited handsomely from the run-up in prices over the last seven months. Once again, the chart tells the story better than words ever could...
Here's a chart showing the Oil Index over the past year. We've superimposed the 20- and 50-day Moving Averages, as well as the DMI and ADX indicators below. Basically, DMI and ADX tell you whether the market is trending. As a very simple rule of thumb, watch for the following signals:
Here are a couple of observations based on this chart:
Using this system we could have purchased oil-related securities in March and profited accordingly. Who knows, perhaps you could have paid for this winter's heating bill!
We don't have a crystal ball, but... +DMI is still above - DMI and ADX is above 25, offering evidence of a continuing bullish scenario for the oil market. No matter what the prices do in the coming months, you can always gain some helpful insight by taking a look at DMI and ADX.
If you agree that this system looks useful, you may want to analyze some of the other sectors using the same approach.
TIPS & TECHNIQUES - Using Directional Movement
The DMI system is an effective and frequently used trend indicator. This system is made up of three lines:
Here you'll find several helpful refinements to using the DMI system, including Wilder's Extreme Point Rule.
PROFIT POTENTIAL - Imperial Oil
We might as well continue with the Oil theme as we take a look at a current market using DMI & ADX. Imperial Oil (AMEX) is in a current uptrend after going sideways through most of the summer. The DMI indicator is currently confirming the uptrend and will likely offer good signals to inform us when Imperial Oil forms a peak and reverses trend. Let's take a look at the chart...
In the top chart we've plotted a 6-month price history of Imperial Oil along with its Parabolic SAR (more about this later), and in the bottom chart the DMI & ADX indicators. Once again the trendlines (drawn in blue) show the major trend.
Point A: Here we can see that ADX was warning us that the uptrend of Apr-May was over when it dropped down through both DMI lines as well as the 20-25 level at the same time. This was a clear indication to momentum traders to sell any long positions. With ADX below 20, we would have been wise to ignore the subsequent DMI crossovers.
Point B: When ADX formed a bottom in mid-August, at the same time that + DMI crossed up through - DMI, we had a signal that the sideways trend might be over. This was confirmed when ADX crossed up through the 25 level. Here's a second view of Imperial Oil, this time for a one-year time period.
Here again, we've ignored the DMI signals offered while ADX was below 20, and I've used the same set of signals as before:
At Point C on the chart above, ADX forms a peak. According to Wilder, a peak or reversal in ADX when it is above both DMI lines, is a good indication of a peak in the market.
Now, let's take a quick look at the Parabolic SAR. The dotted line of the Parabolic indicator typically switches from one side of the price line to the other. (Parabolic SAR offers a buy signal when it switches from above the price to below, and vice versa for a sell signal). In both charts, we can see that the DMI/ADX system would have proven useful in confirming the signals offered by the Parabolic indicator.
These two sets of indicators work very well together in determining trending markets and trading them profitably. For example Wilder has determined that you can ignore Parabolic SAR sell signals when the + DMI is above - DMI and the ADX is above 25. We've marked such a "false" signal at Point D on the one-year chart.
Indications are currently looking positive for Imperial oil:
Bearish signals to watch for: if the ADX is above both DMI lines and forms a peak and/or + DMI crosses down through - DMI, you should anticipate a market peak or top.
Putting ChartFilter into Context
ChartFilter is meant to complement your overall trading knowledge and decision-making. This newsletter focuses on applying technical analysis (TA) methods to various markets; but this is not to say that you shouldn't be considering important fundamental criteria, such as EPS or revenue, as well. Think of ChartFilter as your TA assistant; not as your overall trading strategist.