DMI helps investors to even ASSESS the STRENGTH of a trend
The directional movement indicator was developed by Welles Wilder. It is a useful tool for identifying the presence of a definable trend and assessing its strength. A line scaled from 0 to 100 per cent is used for rating the directional movement of a price. The higher the value of the DMI, the stronger the signal for a trend. On the other hand, the lower this value is, the less the potential for a trending price movement.
Two lines are needed that reflect the buying and selling pressure in the drawing of a DMI indicator chart. The positive directional indicator, marked as +DI (Positive Directional Index), measures how strong the price movement in an upward trend is, whereas the negative directional indicator is marked as -DI (Negative Directional Index) and measures how strong the price movement in a downward trend is.
The first thing to look for when examining the DMI lines is which of the two is higher. Some trend traders refer to the line on top as the dominant DMI line and consider it stronger and more likely to forecast the trend direction. It is presumed that bullish market conditions are experienced when the -DI is lower than the +DI. The reverse is true for bearish market conditions.
Calculation of the DMI is a bit complicated and not easy to understand. So, rather than getting into that confusion, one should concentrate on using it with the help of technical analysis software, which provide hassle-free plotting of the DMI indicator. The ideal parameter for DMI is 14. The indicator, when plotted on intraday charts, can give intraday buy-sell signals and when plotted on daily or weekly charts, can give short to medium-term investment signals.
Most of the Technical Analysis software uses a green colour for the +DI line and a red colour for the -DI line.
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AVERAGE DIRECTIONAL MOVEMENT INDEX (ADX)
The average directional movement index (ADX) represents a moving average of the DMI. The ADX is constructed by the use of the direction indicators +DI and -DI, and is used in order to determine the strength of the trend.
The ADX is measured on a scale between 0 and 100. If the value of ADX is below 25, then it is considered that there is no clear trend for the underlying. However, if the value starts to move above 25, then this movement is a warning signal about the beginning of the formation of a trend. Crossover above or below the 25 level can be observed easily by the equilibrium used by the indicator on the charts. Readings over 40 indicate a strong trend. The trend has been exhausted when the value of the ADX has been above 40 but starts to move down.
Most of the technical analysis softwares use a bold white or black colour line for ADX.
So, the main difference between DMI and ADX is that DMI indicates the trend, while ADX indicates the strength and momentum of that trend, whether it is bullish or bearish.
Both DMI and ADX may be used for generating trading calls individually, but when used in combination, it increases the reliability of the signal generated. Let us discuss all the trading signals indicated by the DMI and ADX.
BULLISH SETUPS
* +DI line crosses the -DI line upside
* +DI line reaches above the 25 level, coupled with -DI trading lower
* ADX line crosses the 25 level upside, coupled with +DI holding above 25 and -DI holding below the 25 level shown by the equilibrium line
* ADX line crosses the -DI line upside, when both these lines are placed below the 25 level, while the +DI line is placed above this equilibrium level.
Among all of the bullish setups discussed above, the first setup is probably the most common signal and so, is the least reliable. If not used in conjunction with other technical analysis tools, these crossovers can lead to whipsaws and many false signals.
However, the last one is probably the least common of the four signals, but is usually the most reliable, and leads to the biggest moves.
Bearish Setups
* -DI line crosses the +DI line upside
* -DI line reaches above the 25 level, coupled with +DI trading lower
* ADX line crosses the 25 level upside, coupled with -DI holding above 25 and +DI holding below the 25 level shown by the equilibrium line
* ADX line crosses the +DI line upside, when both these lines are placed below the 25, while the -DI line is placed above the equilibrium level of 25.
Historically, it has been observed that any level above 50 for both the +DI and -DI line acts as an overbought zone for the existing trend. For, most of the time, the underlying push loses its momentum and changes the trend from bullish to bearish/sideways or bearish to bullish/sideways.
PRACTICAL EXAMPLES
Here, we have taken back- to-back, three practical instances of DMI sell signals given during the bearish trend which started in January 2008. The first signal was generated by the ADX and DMI on January 18, when the Sensex was trading at 19,013. Thereafter, the Sensex plummeted by 23 per cent, testing the level of 14,677. The second sell signal was generated on June 2, 2008, which resulted in an added 22 per cent fall, taking the Sensex to 12,514. The third signal was generated on September 29, 2008, resulting in another huge cut of 38 per cent in just 18 sessions. The average return of all these three sell signals generated by DMI was 28 per cent.
DMI Buy signal on Cipla Daily Chart: Here we have taken, back on back, three practical instances of DMI buy signals given during the bullish trend which started in March 2009. In all the instances shown in the chart, the average return was 20 per cent in Cipla.
The writer is director and head of research, Anagram Capital