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Adx Comparison

In: Business and Management

Submitted By aca711
Words 1346
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The DMI, or Directional Movement Index, was developed to determine how much directional movement - or trend - is in a market. It is often combined with the Average Directional Movement Index (ADX) study.
The DMI is plotted as two lines. You can determine Bullish or Bearish trend direction by two directional indicator values - +DM and -DM. The calculation determines the relationship of the current close to the previous close. If the current close is higher, a greater value is placed on the +DM and a lower value on the -DM. This means in a strong trend, the lines will move in opposite directions, and in a correction or sideways move they will converge. There is also a calculation connected to a range, Average True Range, or DMIATR, so if a range begins to contract in a trend, the lines may also begin to converge as momentum slows.
The formulas for determining DMI and ADX are not complex. You must first determine the Directional Movement - DM - for the current trading interval. After several more mathematical steps, a DM value between zero and 100 is determined.

DMI can be used as both an entry and as an exit tool. As an exit tool, the chart shows the DMI and the DMI Difference, or DDIF. Although the DMI study does have a limit of scale, it is very rare for it to get near to those limits especially on the upside. Therefore, the DMI Diff can be used to gauge levels of Overbought and Oversold. When the difference is greater than 30, except in very strong trends, it indicates the potential of a correction or change in trend. 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 intraday tool. The signals shown on Chart One show that the DDIF is greater than 30, but the difference is now less than it was for the two previous bars. The calculation can indicate buy exits on a down bar and vice versa, and when this occurs an exit is activated on the first reversal bar after a signal.

[pic]

Methods for entry typically include the ADX study, as well. The ADX study measures the strength of the trend. When rising, a trend is in progress, and when falling the trend is correcting, the market is trading sideways. ADX does not understand trend, so will rise if the trend is in either direction. The signals on Chart Two shows the ADX is above 65, indicating the trend is very close to ending

[pic]

An additional filter can be used when the DMIs cross and the ADX has risen in value from the previous bar, as shown in Chart Three. You can wait for the ADX to rise before trading in the direction of the highest DMI value, although you will often miss the beginning of any trend.

[pic]

Finally, when ADX rises above both DMI lines this indicates the trend is extending, stops can be tightened, especially if the DMI diff is contracting. When the ADX turns down the exit is activated. Since the ADX does not understand trend direction (i.e., a strong trend in one direction is followed by a strong trend in the opposite direction), it will continue to fall as it needs time for the calculation to unwind from the previous move.

DIRECTIONAL MOVEMENT

Overview
The Directional Movement System helps determine if a security is "trending." It was developed by Welles Wilder and is explained in his book, New Concepts in Technical Trading Systems.

Interpretation
The basic Directional Movement trading system involves comparing the 14-day +DI ("Directional Indicator") and the 14-day -DI. This can be done by plotting the two indicators on top of each other or by subtracting the +DI from the -DI. Wilder suggests buying when the +DI rises above the -DI and selling when the +DI falls below the -DI.

Wilder qualifies these simple trading rules with the "extreme point rule." This rule is designed to prevent whipsaws and reduce the number of trades. The extreme point rule requires that on the day that the +DI and -DI cross, you note the "extreme point." When the +DI rises above the -DI, the extreme price is the high price on the day the lines cross. When the +DI falls below the -DI, the extreme price is the low price on the day the lines cross.

The extreme point is then used as a trigger point at which you should implement the trade. For example, after receiving a buy signal (the +DI rose above the -DI), you should then wait until the security's price rises above the extreme point (the high price on the day that the +DI and -DI lines crossed) before buying. If the price fails to rise above the extreme point, you should continue to hold your short position.

In Wilder's book, he notes that this system works best on securities that have a high Commodity Selection Index. He says, "as a rule of thumb, the system will be profitable on commodities that have a CSI value above 25. When the CSI drops below 20, then do not use a trend-following system."

Example
The following chart shows Texaco and the +DI and -DI indicators. I drew "buy" arrows when the +DI rose above the -DI and "sell" arrows when the +DI fell below the -DI. I only labeled the significant crossings and did not label the many short-term crossings. [pic]

Trending Indicators: DMI The Directional Movement Index was created by J. Welles Wilder, Jr. The index helps investors determine whether a security or index is trending, which way the trend is, and whether or not that trend is accelerating or decelerating.

The system is derived by identifying the portion of today's range that is outside the previous day's range. If a stock's range is more above the previous day's range than it is below, that above portion is added to the positive DMI (+DMI). If a stock's range is more below the previous day's range than it is above, that below portion is calculated for negative DMI (-DMI). This might sound confusing but don't worry: the majority of investors use charting programs to calculate the index and therefore it is not necessary to understand how it is computed though it can help.

A third line is calculated known as the ADX. This represents the Average Directional Indicator which simply measures the spread between positive and negative DMI. It will tell us whether a trend is strengthening or weakening.

The first thing we must determine is whether or not a trend exists. This can be measured through the ADX. When the ADX is rising, the stronger market crowd is gaining on the weaker. When it is falling, the weaker crowd is gaining on the smaller. Therefore, only use the index when ADX is rising. When it's falling, it often means the security or index is under consolidation.

Once we've determined that the security or index is trending, we can analyze it. The index is built on determining which crowd, bulls or bears, are more consistently moving a stock above or below the previous day. Therefore when the positive DMI is above the negative DMI, it indicates that bulls are stronger than bears. Vice aversa, when the negative DMI is above the positive DMI, bears are in control.

The best time to be long is when the positive DMI is above the negative DMI and ADX is rising. The best time to be short is when the negative DMI is above the positive DMI and ADX is rising. Investors often also use crossovers between the positive and negative DMI to buy or sell. The ADX is a powerful tool. When it's rising, being on the side of the stronger market crowd pays off largely.

Below is Dell Computer's chart with the Directional Movement Index included:

[pic]

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