The widespread use of personal computers gave traders and investors the possibility to perform advanced computations to obtain knowledge out of the bare prices. Numerous traders think there’s a covered structure in the price action, and the difficult and computationally challenging the indicator is (such as ARIMA, MESA or Fourier analysis) the better. Sadly, there’s no computational code able to expose the strange turns of the markets, and, if one is found, it is unlikely the person or organisation owning it will publish it. (Although I honestly think there’s no such formula).
However, that doesn’t imply that technical studies are useless. Well known and relatively simple indicators exist that are capable of delivering information about the state of the price or market. Information which would be hard to detect by merely looking at the movement of prices.
Directional Movement(DMI) and the Average Directional Movement Index(ADX):
The DMI study was designed as a response about two issues trend followers needed an answer for:
- Is price moving in a trend? and
- How strong is it?
Furthermore, these questions aren’t trivial. Trend followers want to get into a position at the early stages of a trend, usually when a breakout occurs. However, if the price isn’t trending, their entry fails, generating a loss. That can happen several times, creating a painful losing streak.
A precise interpretation of ADX help traders to evade possible losses due to false breakouts, helping them filter out potentially bad trades and focus on trendy enough markets. ADX is, also, a helper tool about when to switch from a trend-following strategy to other trading tactics when the signal reveals that the price is not trending.
The Directional Movement was developed by J. Welles Wilder, Jr, and explained in his book New Concepts in Technical Trading System (1968). The DMI study is a handy technical indicator that shows the market direction. One of its derivations, the ADX, quantifies the strength of a trend.
The directional movement DI arose from the idea that if there is an uptrend the current bar’s high should be over the prior bar high. Conversely, if there is a downtrend in place the current bar’s low should be below the low of the former bar. The difference between the actual high and the prior one yields +DI, while, the difference between the present low and the former one results in –DI. Inside bars are disregarded.
- If the present bar’s range goes over the previous bar’s range, there’s a new +DM value; while –DI = 0
- If the current bar’s range moves below the prior bar’s range, there’s a new –DM value, while +DI = 0
- Outside bars (whose low and high are beyond previous the bar’s range) has both, positive and negative DM. The larger will be used and the shorter equated to zero.
- On an outside bar, if +DM and -DM values are identical, then both DM = 0
- On Inside bars, both DM = 0
DI, the directional indicator, is calculated by dividing DMby the True Range (TR).
DI = DM / TR
TRis the largest of these three figures:
High – low
High – close
The resulting DI number can be positive or negative. If positive (+DI), it shows the per cent of the current bar’s true range that is up. If negative (-DI), it shows the per cent that is down for that bar.
The DI’s are averaged over a certain period. Mr Wilder recommends 14 bars.
The computation for 14 bars is:
+DI14= DM14/ TR14
Where DM14and TR14are the averages of these figures over a 14 bar period.
The DX is derived from +DI and +DI, using this steps:
- – We compute the absolute difference:
DIdiff= | [(+DI) – (-DI)] |
- 2,. We find also the sum:
DIsum= [(+DI) + (-DI)]
- – We compute the DX:
DX = 100 xDIdiff/DIsum
The 100-factor scales the DX values between 0 and 100.
The DX is too erratic to be applied directly. Therefore we create a moving average of DX which is called Average Directional Indicator, ADX. This average usually is made using the same period as the one to obtain the DI.
Another indicator can be extracted employing a momentum-like derivation of ADX called Average Directional Movement Index Rating (ADXR)
ADXR = (ADX – ADXn) / 2
Where ADX is the ADX value of the actual bar, while ADXnis the one for the nth bar ago.
When represented it on a chart, if +DI line is over –DI line, then the trend bullish. The opposite situation indicates a bearish move.
If these two lines diverge, the directional movement strengthen. The larger the difference, the stronger the trend.
According to Wilder, the 14-period averaging was picked to match his view of a typical half market cycle. Swing and day traders may want to adjust it to agree with the half cycle of their trading time frame. For example, LeBeau and Lucas in his book recommend a 12-bar period when trading on 5-min charts.
The DMI/ADX in action
Fig 2 shows the hourly EUR/USD and the DMI/ADX study. We observe that the ADX is below 25 in the left quarter, where a trend ADX is missing. The +DI and -DI lines touch each other, and these lines are mingling each other every few bars. Then, the breakout seen in the price is in sync the growth of the ADX line, at the same time the +DI crosses over –DI. The ADX signal rises while the trend continues moving up with increasing power.
The top price formation alters its shape, and now it moves down following the price until –DI crosses over +DI and, then, ADX starts meandering, while price moves in a corrective wave and creates a double top. The price starts dropping at the same time a new Upward DMI leg is seen. We can see that every time the DMI starts a new upward leg, there is a continuation of the current trend. Then, a new bottom forms, with a reset of the ADX and DM down to the 25 mark. When the new upward movement happens it triggers the same cyclic behaviour as has happened in the previous wave.
It looks sluggish and untimely. A lot of traders dismiss it for this, but we must remember the ADX displays only the force of the trend.
The DI system traces the fight among bulls and bears. It assesses the power of bulls and bears to drive prices beyond the past bar´s range. When +DI is over -DI it proves that bullish sentiment ruled the market so far. -DI above +DI reveals that the bears are in charge. Thus, a trader that follows the direction the upper line maks has an edge.
ADX moves upward when the spread between +DI and –DI increases. It shows that the sentiment (bull or bear) of the dominant market group is gaining force. Therefore, the bias is probably continuing.
The ADX drops when +DI and –DI distance is diminishing. That reveals that the ruling group is losing force and the health of the market movement is questionable.
Rules for trading with ADX and ± DI:
The real advantage of the ADX is its use as an entry filter. It’s crucial to be aware that the ADX by itself doesn’t expose the market direction, but the strength of the current price action. We must employ the +DI and +DI crossovers to delimit direction.
- If +DI is over –DI then the trend is bullish. If the opposite is true, the trend is bearish. Consequently, we filter the trades in opposition to the trend direction signalled by the information +DI and -DI is supplying.
- When the ADX decays, it’s an evidence of a market top or bottom, and we should exit our position or tighten the stops. As long as the ADX is decreasing, better not to use any entry strategies intended for trend-following markets.
- When the ADX is near or below the DI lines, it warns of sideways or flat price action. Under these circumstances, breakouts have a higher chance to fail. Better wait for the ADX to rise again.
- The ADX line under both DI lines is a sign of very low volatility, and, indeed, the price is in a very quiet horizontal channel. Thus, a breakout of this area is a perfect opportunity, since the reward to risk ratio must be excellent.
- Finally, when the ADX is well beyond the two DI lines, it possibly is a sign of an overbought or oversold condition. If, then, the ADX stalls it may be the moment to profit taking, or at least reducing positions and tightening stops.
Computer Analysis of the Futures Markets, Charles LeBeau and David W. Lucas.
The New Trading for a Living, Alexander Elder.