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- Tips on Technicals - The Directional Movement System

By Michael N. Kahn

Most technical tools used today fall into one of two categories, oscillators and trend followers. RSI and Stochastics are examples of the former and moving averages and bands are examples of the latter. However, not all studies are effective in the different types of markets. Trend following studies often cause false signals, and hence losses, in flat or erratic markets. Welles Wilder has developed a system to determine whether the market is in a trending mode and if so, how strong that trend is. The Directional Movement System, while simple to use, is too complex in its calculation to explain. We will only cover the basics here.

Definition of Directional Movement

Wilder has taken the concept of direction down to the individual bar level. For daily analysis, he compared today's bar with yesterday's. If the trading range for today extended primarily above yesterday's then directional movement was considered to be up. If it extended primarily below yesterdays' range then directional movement was considered to be down. There are also rules for handling inside, outside and limit days. He summarized this by stating that the directional movement is the largest part of today's range that lies outside yesterday's range.

Just like with RSI, Wilder sums up the positive directional movements (+DI or PDMI) for the past "n" days and the negative directional movements (-DI or MDMI) for the past "n" days. These values are standardized across all markets by dividing them by their recent price range for a result ranging from 0 to 100. These standardized values are called +DM and -DM.

Figure 1

Simple Usage

This system can be used as a filter for more traditional studies. For example, in Tips Volume 2, No. 20, "RSI vs. Stochastics" we explored when each of these two indicators was better. RSIs worked well in trending markets and Stochastics worked better in flat markets. By simply taking a DMIA reading, a more systematic approach can be used. If DMIA is above 25-30, a trend following system or strength oscillator can be used. If it is below 25-30 then an alternate should be used.

If several markets are being followed, the ones with the highest DMIA values can be traded for the medium and long terms using momentum indicators and trend followers. Markets with low DMIAs can be traded in the short term using volatility measure such as Bollinger Band constriction (Volume 2, No. 10) or price elasticity measures such as Market Profile (Tips Volume 2, No. 3).

Trading with +DM and -DM

The first part of the full system is simple; buy when +DM crosses above -DM and sell when the reverse occurs. When +DM is greater than -DM it means that days where the trend was up outweigh the days when the trend was down (over the past "n" days). The greater the difference between the two values, the stronger the trend The next step in using the system is to calculate the difference between the two lines and plot it separately. This allows for one number to measure the strength of the trend. Note that this is not a simple spread calculation but rather a percentage measure of net directional movement. This value is called the Directional Movement Index and is abbreviated either DMI or DX. Typically, values above 25-30 indicate a significantly trending market. The Directional Movement System uses a moving average of the DMI called either DMIA or ADX.

Figure 1 shows 300 days of the US Bond continuous futures contract with a 14-day Directional Movement System. During early 1994, Bonds were in a strong trend lower. -DM was above +DM so the Directional Movement System indicated a short position. The DMIA value was rising and eventually topped out in the 50's. In April, the DMIA flattened and reversed, indicating that the trend had halted. It is at this point that the trader would stop using trend following systems as this market has entered a choppy trading phase.

New positions are initiated when the DMIA line crosses above both +DM and -DM and the DMIA is rising. In Figure 1, after exiting the short position in April, No. new positions were initiated until September when a new short was indicated by DMIA rising. This trade lasted for only a few days as DMIA once again reversed.

In November, the DMIA once again began to rise but this time the +DM had crossed above the -DM. A new trend had begun but this time it was bullish. Each time the DMIA reversed, a trade was either closed if already open or opened long or short depending on the +DM and -DM relative positions.

Summary

Many technical indicators are prone to "whipsaws" in non-trending markets. Wilder's Directional Movement Index System can help determine if a trend is in place so that these indicators can be chosen accordingly. More advanced analysis can be applied to crossovers of its components but we will leave that for another edition.


Michael N. Kahn is a columnist for Barron's Online based out of Florida. He also writes a free technical newsletter. To subscribe to this service, please visit www.midnighttrader.com. The complete collection of Michael Kahn's "Tips on Technicals" is available in Real World Technical Analysis.


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