How to use the DMI indicator to spot trend direction and strength

 

To make a profit from the markets … quite simply, we need to know what direction it’s moving in … and whether it’s going to carry on moving that way.

Spotting direction is relatively easy – depending on the timeframe you’re watching, you can see if it’s just moved up or down.

But what’s tougher is knowing whether it’ll continue to move in that direction. In fact, that’s the thing we’ll never KNOW for sure. But we can make judgement calls on it, based on how powerfully it’s moving right now.

If the price is charging away in an upward direction … yes, it could stop and turnaround, but there’s a good chance it’ll keep going until that move fizzles out.

So, if we can see a clear direction, and a measure of strength … well, that’s about as good a trading signal as we can hope for.

Which is why I’d like to talk about an indicator we haven’t looked at in Trader’s Bulletin for some time: the Directional Movement Index.

How the directional movement index works

The directional movement indicator is made up of three lines below your usual price chart:

• +DI: this is the upward directional index
• -DI: this is the downward directional index
• ADX: this is a measure of trend strength

It’ll look something like this …

Generally speaking, if the +DI (green line) is above the -DI (red line), we’re looking at an uptrend. If the -DI line is above the +DI line, we’re looking at a down trend. And if the ADX is below the 20–25 level, we don’t have a strong enough direction to call a trend at all.

As you can see from the price action in the chart above, it can give some very positive results.

I’m a big believer in keeping our signals nice and simple … but just using one indicator leaves us very vulnerable to false signals. Just as the example above shows some perfect trade set-ups … we can also find places where the DMI indicator will let us down …

Here, the ADX is still above 20, but sideways action sees signals flip from one direction to the other, with no clear direction of trend strength.

No trading indicator can get it right all the time, but by using multiple signals as confirmation for each other, we can create much more solid and reliable trading methods.

Making the DMI indicator work better

Rather than using this indicator in its most basic form, I’d like to look at using it to confirm a signal, so we can be confident that we’ve checked our signal for strength and direction before we place the trade.

What I’m suggesting is that wherever we have a buy signal, we crosscheck the DMI and ADX levels for confirmation.

We’ll only take a BUY trade if:

• +DI >= 25
And
• ADX >= 20

We’ll only take a SELL trade if:

• -DI>= 25
And
• ADX >= 20

What this aims to do is to keep us out of trends when the market direction isn’t clear or strong enough.

Let’s see it in action

Here I’m applying this filter to a simple moving average crossover signal …

With any trading indicator, we must remember that the line on your chart doesn’t have any magical fortune-telling power. It only has the data in front of it (or, more accurately, behind it) to go on. But it can help us to view a jumble of red and green candles in a clearer way.

The upshot of any added confirmation filter is that you’ll get a lot less signals to actually trade on. But we should view this as a good thing if it filters out the weaker signals and only gets us into the strong ones.

The result is less risk … a higher win rate … and higher long-term profitability.

 

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