The Directional Movement Index, DMI, is an effective and frequently used trend indicator. This system was designed by Welles Wilder Jr. and is made up of three lines:
In the example above two clear buy signals have been generated. The first could have been ignored because ADX was very close to 25 - a potential danger signal. The second was perhaps more significant, even though ADX was trending downwards. It did provide a clear indication of the beginning of a very strong move in this market.
Buy and sell signals are given when +DI and -DI cross. The time periods most commonly used in the complex formula are 10 or 14 days.
According to Wilder the DMI should be used with the ADX as a filter.
Generally speaking, the two main buy and sell signals generated by DMI are as follows:
However, some refinements are suggested by experienced traders:
Wilder himself developed a refinement to take care of whipsawing (when the DI lines cross back and forth over a short period, providing unreliable signals). He called it his Extreme Point Rule.
The Extreme Point Rule is derived by noting the high or low point on the day when the +DI and the -DI cross one another. +DI determines the high or low point (if +DI is above -DI the Extreme Point is the high of the day, if +DI is below -DI, the Extreme Point is the low for the day).
The extreme point is then used for the actual buy or sell signal. For example, if the price once again rises above the Extreme Point price level you have a buy signal. If the price fails to rise above the extreme point, you should continue to stand aside. The converse holds true for sell signals.
An additional indicator, the average directional movement index rating (ADXR), was created by Wilder as a measuring tool for the strength of ADX. ADXR is the average of the current ADX and the ADX 14 days ago. ADXR is typically plotted alongside ADX on the same chart.
Also see the Parabolic SAR indicator.