The Directional Movement Index (DMI), developed by Welles Wilder and explained in his book New Concepts in Technical Trading Systems, helps determine if a security is "trending”. Welles Wilder’s Directional Movement decomposes price movement into a positive and negative component. It is made up of 3 indicators which are:
• The ADXR line is the Average Directional Movement Index and indicates the strength of the trend on a scale of 0 to 100. The higher the value, the stronger the trend, whether up or down. A very low ADXR (below 20) indicates a non trending environment.
• The +DI line is the Positive Directional Indicator and indicates what percentage of the true range over the period selected is up movement. This indicator measures upward movement.
• The -DI line is the Negative Directional Indicator and indicates what percentage of the true range over the period selected is down movement. This indicator measures downward movement.
Using a computer program or a charting software, select 14 for the period. For example on the above daily chart of FTSE 100, the period for the DMI is 14 days.
Buy signals are indicated when the +DI rises above the -DI, and sell signals are indicated when the +DI falls below the -DI. In addition, this indicator gives early warning signals. Each time the ADXR line changes direction it is a warning that the +DI may cross over the –DI (or the –DI may cross over the +DI).
On the above chart of BAE Systems, we can see three signals, two buy signals and one sell signal. When the +DI (blue line) rises above the –DI (red line), it is a buy signal. This signal occurred in February and May this year. In April the DMI gave a sell signal when the +DI fell below the –Di.
In an uptrend, when the +DI (blue line) falls to an extreme low, it's a buy signal. Take a look at the daily chart of Prudential below with the DMI at the bottom. I said earlier that buy signals occur when the blue line crosses above the red dotted line. A more aggressive approach is to buy when the blue line is near a previous low - before it turns up and crosses above the red dotted line. The first thing to do is to check past DMI levels when pull backs ended. For the DMI period we use 14.
In a downtrend we do the opposite. When the +DI is near an extremem high it's a sell.