The directional movement Index is one of Welles Wilder’s lesser-known creations, but it is explained in his book “New Concepts in Technical Trading Systems” published in 1978. Many of the most common indicators and use the today originate in this seminal book on technical trading. Consider the ADX, RSI, Average True Range; the Parabolic SAR and the Directional Movement Index all come from the same volume. If you have not read this book yet, it should be on your required reading list as it is truly one of the classics in trading.
The Directional Movement Index (DMI) is a momentum indicator. It calculates the strength of the upward movement or downward moment and shows the results as a trend strength line, also called the ADX. But for the purpose of this article, we will exclude analyzing the ADX and speak strictly of the DMI. The indicator is recognizable by two distinct lines called the +DI and the –DI.
The + DI measures the upward pressure, or upward movement or buying pressure (take your pick of which term you prefer) and the -DI measures the negative or downward movement, or selling pressure. When the two lines cross it can be a buying signal if the + DI crosses over the -DI, and conversely if the –D1 crosses over the + DI is considered a selling signal. Wilder also theorized that when a crossover takes place, it can be seen as a trend reversal.
My experience with the DMI, which is extensive, would suggest that the crossover points are not necessarily indicative of trend reversals. On the contrary, depending too heavily upon the DMI can cause you to be whipsawed in tightly congested markets. So I discount Welles Wilder’s theory on crossing points being indicative of trend reversals.
In non-trending markets the DMI can be confusing and cause many false buy/sell signals. For that reason, I do not use the DMI and consolidating or congested markets. However, in trending markets the DMI can be quite useful in identifying potential retracements, and when combined with Fibonacci retracements, can allow you to obtain a few extra points playing the retracements in a broader trend.
To Welles Wilder’s credit, he was aware of the whipsawing tendencies of the DMI and places a limitation upon its use. Wilder thought that you should not instigate a long position in until price has taken out the high posted on the day or the bar that the+ DMI crosses above them but -minus DMI. This caveat does tend to lessen the number of spurious crossovers the DMI can display, but I’m still not comfortable using the DMI as a primary indicator in my futures trading.
On the other hand, the DMI is a great backup indicator, especially since it is momentum-based, to filter trades off of your primary indicator. This is the exact role I have implemented to use the DMI and have been pleased with the results.
In summary, the DMI is not an optimal primary buy/sell indicator because of the false and/or spurious buy/sell indicators it routinely indicates. But it can be very valuable as a filter indicator to back up the validity of your primary indicator and ultimate trading decisions. Finally, I have used the DMI and trending markets to identify retracements with great success and it truly shines in this capacity.