Directional Movement Indicator

 The Directional Movement Indicator actually comprises two indicators. One is the Positive (+) DMI and other is the Negative (-) DMI. +DMI measures the strength of the uptrend while -DMI measures the strength of the downtrend.

The +DMI is found by calculating the Upmove or +DM, which is current high minus the previous high. If the upmove is greater than the downmove and greater than zero, the +DM equals the upmove else it equals zero.

The -DMI is found by calculating the Downmove or -DM, which is current low minus the previous low. If the downmove is greater than the upmove and greater than zero, the -DM equals the downmove else it equals zero.

Now one has the daily values of +DM and -DM. These values are then smoothened out by averaging over a longer period typically 14 days to calculate the +DMI and -DMI. These values are then plotted as an indicator.

Don't worry if you are overwhelmed by the calculations. We don't have to calculate all this manually. We just need to understand the logic behind the indicator which is to find the strength of the trends direction. The calculations and plotting of the indicator will be done by any advance charts. 

The ADX helps us identify the strength of the trend while the DMI helps us identify the direction of the trend. A simple way to check the dominant trend is to see which of the two lines (+DMI or -DMI) is at the top. If the +DMI is above the -DMI, then a bullish trend is more powerful. If the -DMI is above the +DMI, then a bearish trend is more powerful.

I have divided this chart into three sections based on the ADX. In the first section, the ADX has stayed above 25 from August 2013 till March 2014. This period is the trending phase. During this period, the +DMI has consistently stayed above the -DMI, which means the bull trend is more powerful. Traders would be better off trading the stock only on the long side when the ADX is above 25 and the +DMI is the dominant indicator. Traders can use trending techniques like trendlines and moving averages to identify entry points on the long side and avoid all the signals they may get on the short side.

The second section is the non-trending phase as the ADX has consistently stayed below 25. Both the +DMI and -DMI have also stayed below 25 most of the time. It is best to avoid such stocks as no clear trend is emerging. Traders who still want to trade may use supports and resistance levels to identify trading opportunities.

The third section is again a trending phase as the ADX has moved above 25. Initially, the -DMI is the dominant DMI. You will notice the red line placed above the green line between January to February 2016. This means that bears had the upper hand during that period. However, the +DMI crosses above the -DMI in March. Many traders use a crossover between the two DMI's as entry signals. However, I do not like crossover signals as there can be many whipsaws. I prefer to trade in the direction suggested by the dominant DMI when the ADX is above 25.

So that's how a trader can use the ADX and Directional Movement Indicators to build his own trading system.