DMI Points the way to profits:Part One
The primary objective of the trend trader is to enter a trade in the direction of the trend. Reading directional signals from price alone can be difficult and is often misleading because price normally swings in both directions and changes character between periods of low versus high volatility.
The directional movement indicator (also known as the directional movement index - DMI) is a valuable tool for assessing price direction and strength. This indicator was created in 1978 by J. Welles Wilder, who also created the popular relative strength index. DMI tells you when to be long or short. It is especially useful for trend trading strategies because it differentiates between strong and weak trends, allowing the trader to enter only the strongest trends. DMI works on all time frames and can be applied to any underlying vehicle (stocks, mutual funds, exchange-traded funds, futures, commodities and currencies). Here, we'll cover the DMI indicator in detail and show you what information it can reveal to help you achieve better profits. (For background reading, see Momentum And The Relative Strength Index.)
DMI Characteristics
DMI is a moving average of range expansion over a given period (default 14). The positive directional movement indicator (+DMI) measures how strongly price moves upward; the negative directional movement indicator (-DMI) measures how strongly price moves downward. The two lines reflect the respective strength of the bulls versus the bears. Each DMI is represented by a separate line (Figure 1). First, look to see which of the two DMI lines is on top. Some short-term traders refer to this as the dominant DMI. The dominant DMI is stronger and more likely to predict the direction of price. For the buyers and sellers to change dominance, the lines must cross over.
A crossover occurs when the DMI on bottom crosses up through the dominant DMI on top. Crossovers may seem like an obvious signal to go long/short, but many short-term traders will wait for other indicators to confirm the entry or exit signals to increase their chances of making a profitable trade. Crossovers of the DMI lines are often unreliable because they frequently give false signals when volatility is low and late signals when volatility is high. Think of crossovers as the first indication of a potential change in direction. (For more insight, read the Moving Averages tutorial.)
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