The DMI is a trend following trading system giving specific buy and sell signals. The ADX is used to determine whether how strongly (or not) the market is trending. DMI and ADX were developed by Welles Wilder, the creator of the RSI.
Since the market is in a strong tend only about 30% of the time and is sideways about 70% of the time, this indicator is used to capture the period when the market shows significant trending or directional behaviour.
The average directional index, ADX line is generated from the directional movement index, DMI, which is a trend following trading system. To understand how the ADX is generated we must understand the DMI, but first we focus on the +/-Di trading strategy.
The values of +Di and -Di are based upon the assumption that when the trend is up, today’s high price should be higher than yesterday’s high price (+Di) and when the trend is down, today’s low price should be lower than yesterday’s low price (-Di).
- The positive directional indicator, +Di = Ht – Ht-1
- The negative directional indicator, -Di = Lt – Lt-1
- The greater the difference between +Di and -Di, the more the security is trending
DMI trading signals are given via a simple crossover system:
- BUY SIGNAL: When the +Di line crosses above the -Di line
- SELL SIGNAL: When the +Di line crossed below the -Di line
This is a popular system amongst trend following traders. Longer term traders such as fund managers can use it on weekly data.
The average directional movement index (ADX) averages the difference between the +Di and -Di over the period specified and measures the extent to which a security is trending. Note that ADX is ALWAYS positive, in both uptrends and downtrends.
Therefore, the higher the ADX value, the more trending the security is experiencing (whether up or down). Thus the ADX does not distinguish between a rising and falling trend; it measures the strength of the trend, regardless of direction. It is perfectly normal for the ADX to be rising sharply when the stock’s price is falling because by rising it is indicating the increasing strength of the downtrend. Wilder noted the following:
- Ad ADX value above 25% is indicative of a trending market
- An ADX value below 20% would signify a non-trending market
- Note that some traders adjust these rules: An ADX value above 30%, or ADX above 20% and rising indicates a trending market.
Trades should be taken at the point of the crossover of +Di and -Di.
DMI can be used as both an entry and as an exit tool. When the difference between +Di and -Di is greater than 30, except in very strong trends, it indicates the potential of a correction or change in trend.
Stock markets and commodity markets normally fall more quickly than they rise, so if you wish to adjust these levels, use +30 on the upside and -40 on the downside. This method is used as an intra-day tool.
Below is a EURUSD daily chart with ADX, +Di and -Di lines displayed.
The Genius of the ADX
The ADX is a measure of the trendiness of a security – the presence and strength of a trend. It makes no comment on the direction of the trend. It just answers the question, is there a trend now or not? Methods for entry typically include the ADX study, as well.
When the ADX is rising, a trend is in progress, and when it is falling the trend is correcting, the market is trading sideways. ADX does not understand trend direction, so will rise if the trend is up or down. When the ADX is above 65, this indicates the trend is very close to ending. We have noticed that when we get a reading of over 45 and the ADX turns down, this is often an indication of an important top or bottom.
Wilder said that the ADX shuold be above 25 and rising in order for a trend following system such as the DMI to be profitable. Our own research indicates that this is too strict a filter. Too many good trades are lost. Our view is that the trend following trades (either DMI, Moving Average or any other trend following system) will be profitable provided the ADX is above 20 – it does not matter if it is rising or falling.
(You should experiment for yourself to decide if you believe these observations to be true. See our best brokers to get started on a demo account to test out the ADX & DMI.)
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