Technical indicators help investors to understand market psychology besides demand and supply mechanisms. These indications together form a base for performing in-depth technical analysis. While metrics such as trading volume indicate a price trend’s continuation, indicators generate buying and selling signals. Technical traders and chartists use several indicators, patterns, and oscillators while trading multiple financial markets, including stock, forex, indices, and cryptocurrencies. DMI is also a popular technical indicator used to determine the direction and strength of a price trend. In this piece, we discuss DMI in detail.
What Is DMI Indicator?
Directional Movement Index (DMI) is a technical indicator that helps users determine the asset’s price direction. Founded in 1978 by J. Welles, the technical indicator compares previous lows and highs by drawing positive and negative directional movement lines. Traders sometimes also use the average directional line (ADX) as a third option along with these lines to measure the uptrend or downtrend’s strength.
When +DI exceeds -DI, the price is under more substantial upward pressure. On the other hand, If -DI exceeds +DI, the price is under additional downward pressure. Traders may use this indicator to gauge the trend. Traders might also use lines crossovers as buy/sell signals.
How to Calculate Directional Movement Index (DMI)
Directional Movement (DM) is the most considerable portion of the current period’s price range that sits outside the prior period’s price range. Calculate the DMI for each period.
Positive DMI is equal to High – Previous High
Negative DMI is equal to Previous Low – Low
Reset the smaller of the two numbers to zero, i.e., if +DM is greater than -DM, then -DM = 0. On the inside bar ( a higher low and a lower high), both -DM and +DM have negative numbers; hence you can set them to zero, representing no directional movement for the specific period.
Calculate the True Range (TR) for each period, where:
TR = Maximum of (High – Low) x (High -PreviousClose ) x ( PreviousClose – Low )
Aggregate the -DM, +DM, and TR individually and smooth out using a proprietary smoothing approach developed by Wilder. For smoothing of n period, add 1/n of each period’s value to the total of each period, just like an exponential smoothing.
+DMt is equal to [+DMt-1 – (+DMt-1 / n)] + (+DMt)
-DMt is equal to [-DMt-1 – (-DMt-1 / n)] + (-DMt) (-DMt)
TRt is equal to [TRt-1 – (TRt-1 / n)] + (TRt) (TRt)
Then, calculate negative DI and positive DI as a True Range Percentage as shown below:
+DM/TR x 100
-DM/TR x 100
What Does the DMI Indicator Tell You?
Investors use Directional Movement Index (DMI) to analyze trend direction. Trading signals are crossovers. An uptrend may be underway when the positive DI crosses above the negative DI. On the other hand, a sell signal is generated when the positive DI crosses below the negative DI. When a downturn is underway, traders might initiate a short-term trade.
Traders may also use the indicator for trade or trend confirmation. In this case, the +DI is substantially above -DI, confirming existing long trades or fresh long-term trade indications concerning other entry approaches. If -DI is substantially above +DI, a severe downtrend or short-term positions are confirmed.
How To Read the Directional Movement Index (DMI)?
The DMI is positive when the current price – the previous high exceeds the current low – the previous high. So, if it’s positive, this index is the current high – the previous high.
The reverse is the negative DMI. In this case, the previous low – the current low is greater.
It’s helpful to know the DMI’s theoretical underpinnings. However, that’s not a compulsion anyway. You only need to understand how to employ the indicator when required.
You may notice that the DMI features three lines of varying colors. You may modify the colors to fit your trading style. The yellow-colored ADX line is the most crucial line in the chart above. It tells you what’s going on.
ADX value above 25 indicates a strong trend, whereas ADX having a value below 25 or below suggests there is no significant trend. Likewise, the Redline shows negative DM, while the blue line represents the positive DMI.
How to Use the DMI Indicator?
Traders can find the DMI indicator in toolkits of popular trading platforms, such as MetaTrader & PPRo8. After applying it to a price chart, traders may see three indicator lines: average directional index line, positive DI line, and negative DI line.
The indicator is most often used to gauge a trend’s strength. As a result, it can only be employed in a trending market.
The ADX number is the most typical interpretation. A value above 25 typically indicates a significant trend. Wilder suggested that an ADX of 20 or less indicates no substantial direction.
However, you can always customize these numbers. We know traders that utilized 30 to demonstrate a trend. The chart below is an excellent illustration.
Ensure the chart is going upwards or downwards before using the indicator. This is vital since it won’t work if the underlying asset price fluctuates.
Image Source: TradingView
Please note that the Directional Movement Index (DMI) may not always be correct. Traders should use it in conjunction with other trends, oscillators, and volume indicators. Use methods like candlestick pattern and Fibonacci retracement analysis.
How can Directional Movement Index (DMI) Help Traders Make Profits?
Let’s explore how to evaluate the DMI indicator in-depth and what information it may offer to help you generate higher earnings.
DMI – Trendlines
DMI incorporates the range’s expansion moving average for a specific period, i-e, 14 days. The indicator measure how strongly the price rises upward (+DMI) or downward (-DMI). The two lines show the power of the bulls and bears.
Each DMI has its own line (see Figure 1). Traders first need to identify which line is on the top. Day traders call it the dominating DMI, and it is more accurate and reliable. The lines must cross for sellers and buyers to swap dominance.
A crossing happens when the dominant DMI crosses the DMI on the bottom. While crossovers seem to be a clear indication to go long or short, many short-term traders prefer to wait for additional indicators to corroborate the signals. DMI line crossovers are generally inaccurate, giving misleading alerts during low volatility and late signals during high volatility. Crossovers are the earliest sign of a possible direction shift.
Given above image shows the positive DMI and negative DMI as independent lines. You may notice some false crossings on point one. The dominating positive DMI crossover at point 2 suggests an uptrend.
DMI – Directional Signals
The DMI indicator is used to confirm price action ( Figure 2). The +DMI often moves in lockstep with the price, rising and falling with the price. Notably, the -DMI goes in the opposite direction of price. The -DMI increases when the price decreases and lowers with the price increase. It takes a while to adjust. Remember that a price move’s strength is always captured when peaked in the DMI line.
It’s simple to read directions. The price goes up when the positive DMI rises. On the other hand, when the negative DMI rises, the price starts falling down. But pricing power must also be addressed. DMI strength spans from 0 to 100. The greater the DMI, the more volatile the prices. DMI readings above 25 indicate a strong price direction, while a reading below 25 indicates price weakness.
The above figure shows a choppy DMI at Point 1. With the +DMI over 25 at Point 2, the uptrend continues. At Point 3, +DMI moves in lockstep with price, while -DMI moves in opposition near Point 4.
The ability to view both selling & buying pressure simultaneously is a nice feature of DMI that allows traders to identify the dominant one before opening a position. The strength of bulls (swing highs) is mirrored in the positive DMI peak, while the negative DMI reflects the strength of bears (swing lows). The relative intensity of DMI peaks reveals price momentum and gives timely trading tips. When buyers outnumber sellers, the positive DMI rises above 25, and the negative DMI falls below 25. An upswing is visible here. When sellers outnumber buyers, the negative DMI peaks are above 25, while the positive DMI peaks are below 25. The tendency will be downward.
Price trending hinges on the dominating DMI being strong. A strong upswing will have increasing positive DMI peaks that stay above the -DMI (Figure 3). Strong downtrends are the opposite. In the absence of a dominating force, trend trades are inappropriate since both DMI lines below 25 start moving sideways. The finest trends start after lengthy durations of DMI lines crossing beneath 25. Price will break through support/resistance, and DMI will extend over 25.
In the figure, the positive DMI crosses over 25 at Point 1 and stays above the negative DMI. You may notice that negative DMI did not cross throughout the rise. The buyers ( positive DMI >25) outperform the sellers (negative DMI 25).
DMI lines pivot when the price observes directional change. DMI pivots must have a price correlation with structural pivots. The positive DMI will also have a pivot high when the price does. However, there’s an opposite case with negative DMI since its price pivots low when the negative DMI pivots high.
DMI and price pivots must correlate with interpreting price momentum. Many short-term traders monitor for price and indicator convergence or divergence. Finding fresh pivot highs and +DMI highs is one way to validate an asset’s uptrend. A new pivot low and a new high negative DMI confirm a downtrend. This is a signal to trade the trend or follow the trend breakout.
Divergence occurs when the price and DMI do not agree. For example, when the price rises but positive DMI remains intact. Divergence usually precedes a reversal or retracement and is a risk management indication.
Price and positive DMI both establish fresh highs in the figure above, signifying a long entry. In another case of divergence (Point 2), the price achieves a new high, but the positive DMI does not, resulting in a retracement of the trend at Point 3.
DMI & Volatility
The DMI lines show price volatility. A trend enters a time of consolidation, and then the consolidation undertakes a trend period. Volatility lessens as prices consolidate. Because the buying and selling pressures are about equal, buyers and sellers often agree on the asset’s worth. Once the price has narrowed, it will widen as buyers and sellers cannot agree on a price. When price breaks through the support into a downtrend or bypasses resistance into an uptrend, supply and demand are no longer balanced. Volatility rises as the price seeks a new value level.
When a contraction or expansion range appears, the slopes of the DMI lines shift in opposing ways (Figure 4). Many short-term traders search for occasions when DMI lines diverge, and volatility rises. The more lines divide, the more volatile. Contractions occur when lines move closer together, reducing volatility. Contractions precede retracements.
It’s a downturn’s part in the above figure. Point 2’s contraction causes a reversal that starts with Point 3’s expansion. Price consolidates after Point 4’s contraction.
Limitations of the DMI Indicator
The DMI is a component of the ADX. The DMI trend direction may be combined with the ADX strength measurements. An ADX reading over 20 indicates a significant trend. Whether or not ADX is used, the indicator is prone to false indications.
Notably, positive DI and negative readings and crossings are based on the previous pricing and do not guarantee future results. Unresponsive pricing to a crossing might result in a lost transaction.
A crisscrossed line produces several indications but no price trend. To prevent this, only trade in the greater trend direction by employing long-term price charts, or using ADX readings to identify strong trends.
In line with trend analysis, the price of an asset rises when the pivot highs and lows are rising. The trend remains intact, and the bulls strengthen when price highs are followed by greater positive DMI higher highs. On the other hand, lower pivot highs and lows indicate a decline. When the negative DMI peaks rise, the bears are in charge, and selling pressure increases. When price and DMI agree, you may follow the trend and start managing risk while they differ.
The greatest trading choices are based on data, not emotion. Price and DMI will inform you whether to sell or hold your position. DMI may be used to measure price movement and identify low and higher volatility periods. Irrespective of a bearish or bullish market, DMI has a plethora of information that may help you benefit.
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