The concept of Directional Movement is based on the assumption that in an upward trend today’s highest price is higher than yesterday’s highest price, and in a downward trend today’s lowest price is lower than yesterday’s lowest price. If this is the case, it is a matter of the so-called Outside Days. The difference between today’s high and yesterday’s high corresponds to the Plus Directional Movement (+DI). The difference between today’s low and yesterday’s low is the Minus Directional Movement (-DI). These Outside Days consist of a +DI as well as an -DI.
Days in which yesterday’s highest price or yesterday’s lowest price are not exceeded are described as Inside Days and contain a +DI and a -DI, or zero. Do not let the plus or minus sign designation mislead you. They only indicate upward or downward movement, not values. The directional movement value is always a positive number of absolute value, regardless of upward or downward movement. In the Directional Movement calculation, Inside Days are consequently not taken into account. It is possible for the directional movement to be zero. This occurs when the current trading range is inside the previous trading range, or when the trading ranges, current versus previous, are equal.
To calculate the Directional Indicators (+DI and -DI), further calculation of the True Range is necessary. The true range is always positive and is defined as the current highest value of the difference among today’s highest price minus today’s lowest price; today’s highest price minus yesterday’s closing price; and today’s lowest price minus yesterday’s closing price. Wilder used a constant value of 14 on daily data. His logic for using this value is that it represented an average half-cycle period. When this task is accomplished for the specified interval, you compute the average value of PDI, MDI, and TRUE_RANGE.
The Plus Directional Movement is now calculated. The sum of the +DI over the observation period is divided by the sum of the True Range over the same period. The calculation of the -DI is analogous. The Directional Movement Index (DI) is calculated by dividing the difference between the +DI and -DI by the sum of both figures. The result is a percentage, with which the extent and/or intensity or the trend is quantified. By smoothing this DI, an Average Directional Index (ADX) results.
Properties
Period. The number of bars in a chart. If the chart displays daily data, then period denotes days; in weekly charts, the period will stand for weeks, and so on. The application uses a default of 14.
Interpretation
The DI, Directional Movement Index, is a trend following system. The Average Directional Index, or ADX, determines the market trend. When used with the up and down directional study values, +DI and -DI, the DI is an exact trading system.
The rules for using the DI are simple. You establish a long position whenever the +DI crosses above the -DI. You reverse that position, liquidate the long position and establish a short position, when the -DI crosses above the +DI.
In addition to the crossover rules, you must also follow the extreme point rule. When a crossover occurs, use the extreme price as the reverse point. For a short position, use the high made during the trading interval of the crossover. Conversely, reverse a long position using the low made during the trading interval of the crossover.
You maintain the reverse point, the high or low, as your market entry or exit price, even if the +DI and the -DI remain crossed for several trading intervals. This is supposed to keep you from getting whipsawed in the market.
For some traders, the most significant use of the ADX is the turning point concept. First, the ADX must be above both DI lines. When the ADX turns lower, the market often reverses the current trend. The ADX serves as a warning for a market about to change direction. The main exception to this rule is a strong bull market during a blow-off stage. The ADX turns lower only to turn higher a few days later.
According to the developer of the DI, you should stop using any trend-following system when the ADX is below both DI lines. The market is in a choppy sidewise range with no discernible trend.
Literature
Wilder, J. Welles. New Concepts in Technical Trading Systems. Greensboro, NC: Trend Research, 1978.
Babcock, Bruce. The Dow Jones – Irwing Guide to Trading Systems. 1989.
Colby, Robert F., Myers, Thomas A. The Encyclopedia of Technical Market Indicators. Dow Jones – Irwin. Homewood, IL. 1988.
Le Beau C., Lucas D. W. Computer Analysis of the Futures Market. 1992.
Murphy, John J. The Visual Investor. New York, NY: John Wiley & Sons, Inc. 1996.
Kaufman, Perry J. The Commodity Trading Systems & Methods. NY: John Wiley & Sons, Inc. 1978.
Jobman, Darrel R. The Handbook of Technical Analysis. Irwin Professional Publishing. 1995.
Content Source: FutureSource
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