What is the Directional Movement Index (DMI)?
The directional movement index (DMI) is an indicator developed by J. Welles Wilder in 1978 that identifies in which direction the price of an asset is moving. The indicator does this by comparing prior highs and lows and drawing two lines: a positive directional movement line (+DI) and a negative directional movement line (-DI). An optional third line, called the average directional index (ADX), can also be used to gauge the strength of the uptrend or downtrend.
When +DI is above -DI, there is more upward pressure than downward pressure in the price. Conversely, if -DI is above +DI, then there is more downward pressure on the price. This indicator may help traders assess the trend direction. Crossovers between the lines are also sometimes used as trade signals to buy or sell.
Calculation of Directional Movement Index (DMI)
+DI is the difference between the highest price of the current day and the highest price of the day before, and -DI does the same calculation with the current and previous day’s lows.
The True Range is the greater of the current high – current low, the current high – previous close, or the current low – previous close.
After this one should smooth the 14-period averages of +DM, -DM, and the ATR.
Then we divide the smoothed +DM value by the smoothed average true range (ATR) value to get +DI. Multiply by 100.
Then divide the smoothed -DM value by the smoothed TR value to get -DI and Multiply by 100.
The average directional movement index (ADX) is a smoothed average of DX and is another indicator that is added to the DMI.
For calculating the ADX, one needs to continue to calculate DX values for at least 14 periods and smooth the results for getting ADX.
Directional Movement Index Trading Uses
The DMI can be used in both ranging and trending markets.
Using the DMI to Trade Trends
In general, when the +DI line is above the -DI line, the market is moving in an uptrend, and when the -DI line is above the +DI line, the market is moving in a downtrend. Therefore, when trading a trending strategy, favor long positions when the +DI is above the -DI line. When the -DI is above the +DI, favor short positions. These indicators can be used in conjunction with the ADX to further filter or confirm trade signals.
Using the DMI to Trade Ranges
Other traders prefer to scout out trades that depend on choppy price action. When trading is range-bound and choppy, that means the ADX is likely below 20.
This can present different opportunities, such as an iron condor options spread, in which the trader profits from sideways movement. While these kinds of strategies benefit from ranges, many traders still take a slightly bullish or bearish position on the price, and the directional indicators can be used to establish those positions.
Limitations of the Directional Movement Index
The DMI is part of a larger system called the average directional movement index (ADX). The trend direction of DMI can be incorporated with the strength readings of the ADX. Readings above 20 on the ADX mean the price is trending strongly. Whether using ADX or not, the indicator is still prone to producing lots of false signals.
Notably, +DI and -DI readings and crossovers are based on historical prices and don’t necessarily reflect what will happen in the future. A crossover can occur, but the price may not respond, resulting in a losing trade.
The lines may also crisscross, resulting in multiple signals but no trend in the price. This can be somewhat avoided by only taking trades in the larger trend direction based on long-term price charts, or incorporating ADX readings to help isolate strong trends.