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Trend following is the most important aspects in trading. This is because traders become successful by identifying a trend and following it to the end.
The biggest challenge when trading is on how to identify a trend and when a reversal is about to happen. While no method is accurate, traders use multiple approaches to know when a trend or a reversal is about to take place. One of those approaches is using trend indicators like the Directional Movement Index (DMI).
We will look at the main concepts of directional movement index and how to use it when trading.
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What is the Directional Movement Index?
The DMI is an indicator that was developed by Welles Wilder, who is known for developing multiple other technical indicators (like RSI). The DMI has been in use for more than 5 decades.
Wilder developed this indicator after years of observing the movements in the commodities market. Still, it is popular when used in other types of markets like currencies and stocks (here markets DTTW offers to you).
The average directional index is calculated by calculating the plus directional indicator and the minus directional indicator. The plus and minus directional indicators are calculated by looking at the smoothed averages and are used to verify the direction of the trend.
How to Read DMI Indicator
The DMI is positive when the present price minus the previous high is bigger than the previous low minus the current low. As a result, this index is usually the same as the current high minus the previous high if it is positive.
The negative DMI is the opposite of that. It happens when the previous low minus the current low is bigger than the current high minus the previous high.
Having a good understanding of the theoretical foundation of the DMI is a good thing. However, it is not a requirement that you know it. What you need to know is how to apply it on the market.
How to use the DMI indicator
The DMI indicator is available in most trading platforms like the MetaTrader and the PPRo8. When it is applied, the indicator reveals three lines: average directional index, +DI, and -DI.
The most common method of using the indicator is to know the strength of a trend. As such, it is only used when there is a trend and cannot be used in a ranging market.
The most common interpretation is to look at the ADX number. If the number is above 25, it is usually an indication that a trend is strong. When the ADX number is 20 and below, Wilder suggested that there is no strong trend.
As a trader, you don’t need to limit yourself to these numbers. You can adjust these numbers to fit your style. We know many traders who use 30 as the base number to show a trend. A good example of this is shown on the chart below.
New Zealand/ U.S. Dollar DMI
However, as with all indicators, the Directional Movement Index (DMI), is not always accurate. As such, it is recommended that you combine the DMI with other trend, oscillators, and volume indicators.
You should also use additional tools like Fibonacci Retracement and candlestick pattern analysis.
External Useful Resources
Directional Movement (DMI) on Tradingview
How To Combine The Best Indicators And Avoid Wrong Signals – Tradeciety
