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A View to Underlying Trends Using Directional Movement Indicators
Education | 04 December 2013
By: Stuart McPhee
Articles (22) Profile

Many forex traders believe in the importance of trends, and consequently, they include some trend-following component in their trading strategies. On that note, Directional Movement Indicators (DMIs), developed in 1978 by American mechanical engineer, J. Welles Wilder Jr., are used for identifying when a definable trend is present, its strength, and whether an instrument is trending or not.

There are three parts that comprise the DMI system: the Directional Movement Index (DX), the plus, or positive, Directional Indicator (+DI), and the minus, or negative, Directional Indicator (–DI). These are represented on a chart as three distinct lines.

The formula for these indicators is complicated but the DMI system can be quite effective once you learn how to apply and use it. Understanding how DMIs are calculated is not nearly as important as understanding how to employ them. Your forex trading platform of choice should automatically do the mathematics for you.

Determining DMI Values
To determine the values of these three lines in the DMI system, the actual directional movement (DM) must be calculated first. It’s important to note that the DM can be either negative or positive, and it is labelled as +DM or –DM accordingly. The DM is calculated by determining whether or not the larger part of today’s range is above or below yesterday’s range. If it is above, then +DM will be used, and if below, –DM will be used.

The directional indicator (DI) is determined by dividing the DM by the true range for the period. This figure is multiplied by 100 to arrive at a percentage value. The DX is then calculated by taking the difference between the +DI and the –DI and dividing it by the sum of the +DI and the –DI. The resultant number is expressed as a percentage. The higher the value of the DX, the greater the momentum of the price movement, whether up or down, and therefore, the stronger the trend. The ability to demonstrate the strength of a trend is a key advantage of DMIs.

The DMI system is displayed on charts with three main indicators: the +DI, the –DI, and the DX lines. An example is shown in Chart 1, which is a chart of the Australian dollar – AUD/USD.

In this case, the DX line is blue. The first step in a basic trading strategy would be to identify that a price is trending. This is indicated by the DX line moving upward. Then the +DI and the –DI are plotted on top of each other. When the +DI rises above the –DI, it is a bullish sign; a bearish signal occurs when the +DI falls below the –DI.

For more information about Wilder Jr. or DMIs, I recommend you pick up a copy of his book, “New Concepts in Technical Trading Systems” (Trend Research, 1978), or you can download a free PDF copy here.

Remember: indicators are the result of mathematical calculations done on price data and are displayed on charts. Using indicators, it is possible to anticipate the direction of a price’s movement with a reasonable level of accuracy. However, no single indicator is perfect or will be right all of the time.

Get a free OANDA demo account to experiment with DMIs on the award-winning fxTrade platform.

Stuart has more than 16 years of trading experience under his belt and specialises in technical market analysis of major currency pairs. Apart from being the author of several bestselling trading books, with his most recently released book "Trading in a Nutshell", Stuart contributes to daily newletters and blogs. He also produces articles and videos on the how tos of technical tradings. For more information of Stuart, you can follow him on twitter @stuartmcphee or check him out on Google+.

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