The directional movement system can be quite complicated, but it gives investors and traders valuable information. Although it can be used as a stand-alone system, the real strength of the directional movement system is in helping to deal with the problem that besets every trend-following indicator for stock market technical analysis as well as futures, forex and other types of investments. All trend-following systems tend to give good results only when the price trends strongly. If the market only moves sideways or trends very weakly, results are unsatisfactory. The directional movement system is an attempt to define when markets are trending strongly. When they are, we will use trend-following methods. When markets are not trending strongly, we can stand aside, or use methods that are appropriate for sideways markets.
Without doubt, the directional movement system is the most difficult trend-following indicator to understand. This discussion will be kept as simple as possible. We will start by introducing some new concepts.
The Directional Movement (DM) system requires us to precisely define direction and then precisely measure movement in the given direction.
TO determine the direction of the market, we have to look at ranges. The world range has a very specific meaning in technical analysis. It is defined as the difference between the highest and the lowest price a market trades at in a period. Most commonly, we use daily, weekly, monthly or annual ranges.
Direction is determined by establishing whether the greater part of today’s range is above or below the range of the previous trading day. If the greater part of today’s range is above yesterday’s range, it is called +DM. If the greater part of today’s range is below yesterday’s range, it is called –DM. There can also be zero DM for a day. The various possibilities are shown in diagram 5-1.
In the top row of the diagram 5-1, the right-hand situation shows an upward directional movement. The difference between the current day’s high and the high level of the previous day is greater than the difference between the respective low levels recorded on these days. Therefore, the directional movement is upward. The reverse applies to the right-hand diagram on the second row.
One important thing to understand here is that the plus (+) and minus (-) sign in front of DM only denotes whether the direction is up or down respectively. Both +DM and –DM are always positive numbers, representing the size of the directional movement.
In the previous section, we defined range as the high of a period less the low of the period. This is fine when the range of a bar overlaps the range of the previous bar as in the left-hand side of diagram 5-2.
However, if both the high and low are either above or below the high and low of the previous period, as when the price bar gaps up or down, the true range is the total movement from the close of the previous period to the extreme of the next period. The two possibilities are shown on the right-hand side of diagram 5-2.
The rigorous definition of true range is the greater of:
- The high of today less the low of today.
- The high of today less the close of yesterday.
- The close of yesterday less the low of today.
The true range is always a positive number.
The Directional Indicator
Having precisely defined movement, direction and true range, we can now bring them together into the directional indicator (DI). To be meaningful, directional movement (DM) needs to be relative to the True Range (TR). This is achieved by expressing the directional movement as a percentage of the true range. We therefore calculate what percentage of the true range of a period is either an upward movement (+DM) or a downward movement –DM for the same day. If DM is zero, then DI is also zero.
If we plotted the new +DI and –DI, they would be very volatile, so they are smoothed using an intricate method over a selected period. Welles Wilder used 14 periods, but many analysts use somewhat smaller numbers to obtain earlier signals.
The Average Directional Movement Index
This is where your eyes may glaze over trying to grasp the concept. However bear with it- we are almost there.
+DI is the average of the percentages of the true ranges for those of the last 14 periods that were up periods. –DI is the average of the percentages of the true ranges for those of the last 14 periods that were down periods.
The difference between +DI and –DI is the true directional movement. In other words, the greater the difference between the upward and downward direction movement, the more directional is the market being analyzed. To understand this, consider the extremes:
- The price rises for 14 consecutive days. This would mean that +DI would be a large percentage and –DI would be close to zero. Therefore, in this very directional market, the difference between +DI and –DI would be very large.
- Likewise, if the price falls for 14 days, then –DI would be a large percentage and +DI would be close to zero. The difference between them in this very directional market would be large.
- However, if the price fluctuates over 14 days and makes little progress, +DI and –DI would have similar values. The difference between them in this directionless market would be small.
Welles Wilder then manipulates the difference between +DI and –DI so we have an average percentage directional movement, and averages it over 14 days to obtain a line he calls Average Directional Movement (ADX). As the value of ADX is closer to zero, the market is less directional, or trending. The closer the value of ADX is to 100, the more directional, or trending the market is.
The ADX is always a positive number, and it rises in both uptrends and downtrends. So if the ADX is rising, it tells us the market is trending, but not in which direction. When the ADX tells us the market is trending, we have to look at +DI and –DI to discover the trend direction: if +DI is above –DI, the trend is up; if –DI is above +DI, the trend is down.
A good way to understand how the ADX behaves is to consider that if they price rises for 50 days, the ADX will rise. If the price then falls for 50 days, the ADX will top out and fall as the price begins to fall. However, as the price continues to fall, ADX will start to rise again, because as the price trend turns from up to down, the difference between +Di and –DI will fall; they will cross and diverge again, incrasing the difference between them. ADX will rise, indication the new trend.
We could see this from the price chart, because a trend must be established before the directional movement system will create a reading. The usual way to display the directional movement system is in a sub-chart below the price chart. At first sight it is complicated, because the directional movement system consists of three lines: +DI, -DI and ADX.
In chart 5-1, the sub-chart has been enlarged to show the three directional movement system lines. The +DI line is blue. It will rise when the price is rising or fall when the price is falling. –DI is green and moves in the opposite way of +DI- it rises when the price is falling and falls when the price is rising. The ADX is rex. It is always a smoother line than the other two.
+DI and –DI are a pair that generally move in opposite direction. ADX is a smoothed average of the difference between the two DI lines and therefore tends to rise when the DI lines diverge, and tends to fall when the DI lines converge, though with a time lag.
Directional Movement as a Stand-Alone System
The directional movement system may be used on its own. The essential tactic is buy when +DI crosses below the above –DI, and sell when +DI falls back below –Di.
Chart 5-1 shows that this would have given us a good entry around April 20 and we would still be holding Commander Communications at the end of the chart. However, the problem is when this signal comes in a trading range. Like all trend-following indicators, the directional movement system will be unsatisfactory in sideways markets. An example of an unsatisfactory signal is near the start of chart 5-1, when we get a signal to buy and then another to sell a few days later. To try to avoid these problems, three additional rules are used to reduce the likelihood of losses in sideways markets.
- Only buy when the ADX also turns up from below both the DI lines. This is based on the idea that the best trending moves often come out of dull, sideways markets.
- The low of the day, when +DI crossed below –DI, should be used as a stop-loss level, ignoring crossings of the DI lines. This is to avoid acting prematurely when the DI lines cross back and forth in a sideways market.
- Sell when the ADX turns down from above both DI lines. The ADX tends to turn down from above both lines near the end of trends.
Chart 5-1 shows a trade based on these rules. +DI crossed to above –DI and then ADX turned up from below both DI lines on the day marked B. We would buy the next day with a stop-loss at the low of the B bar. The stop-loss was not violated and the ADX moved above both lines and turned down on the day whose bar is marked S. We would sell the next day.
With hindsight, it can be argued that this sale was premature, because the trend reasserted itself. The reason the sell rule did not work so well is that the trend did not persist strongly for long. Trend-following indicators will work best in strongly trending markets.
Chart 5-2 shows a near-perfect example of these rules, with the buy signal marked B and the sell signal marked S. This is a successful example- the trend was strong and persistent.
Directional Movement as a Trend Filter
Although examples like the ones shown in charts 5-2 and 5-3 can be found, many traders and investors find that while the directional movement system is good at identifying strong trends, other trend-following methods like the parabolic time/ price system and moving averages are more sensitive. They use the directional movement system to identify when to use other trend-following methods. The general rules used here are:
- A market is trending strongly when ADX is above 25.
- If ADX then falls below 20, the market has ceased to trend strongly.
Based on this method, an investor would have used a trend-following indicator from soon after the bar marked B on chart 5-3. Chart 5-4 shows this method even better.
The horizontal yellow line on chart 5-4 marks the 25 level of ADX. The vertical yellow line marks the point where ADX rose above 25 in 1995. We would then have invested in Commonwealth Bank using other trend-following indicators until the vertical blue line in 2002, which marks the point where ADX fell back below 20, marked with a blue horizontal line. However, ADX never fell below both DI lines in 1995, so the stand-alone method described above would not have indicated a buy.
The same approach of using ADX can be illustrated for a trader. Chart 5-5shows an example, marked the same way as chart 5-4 on a daily chart.