The primary objective of the trend trader is to enter a trade in the direction of the trend. Reading directional signals from price alone can be difficult and is often misleading because price normally swings in both directions and changes character between periods of low versus high volatility.
The directional movement indicator also known as the directional movement index - DMI is a valuable tool for assessing price direction and strength. This indicator was created in by J. Welles Wilder, who also created the popular relative strength index. DMI tells you when to be long or short. It is especially useful for trend trading strategies because it differentiates between strong and weak trends, allowing the trader to enter only the strongest trends.
DMI works on all time frames and can be applied to any underlying vehicle stocks, mutual funds, exchange-traded funds , futures, commodities and currencies. Here, we'll cover the DMI indicator in detail and show you what information it can reveal to help you achieve better profits. The two lines reflect the respective strength of the bulls versus the bears. Each DMI is represented by a separate line Figure 1. First, look to see which of the two DMI lines is on top.
Some short-term traders refer to this as the dominant DMI. The dominant DMI is stronger and more likely to predict the direction of price. For the buyers and sellers to change dominance, the lines must cross over.
Crossovers of the DMI lines are often unreliable because they frequently give false signals when volatility is low and late signals when volatility is high. Think of crossovers as the first indication of a potential change in direction. For more insight, read the Moving Averages tutorial. DMI is used to confirm price action see Figure 2. It is important to note that the -DMI behaves in the opposite manner and moves counter-directional to price. The -DMI rises when price falls, and it falls when price rises.
This takes a little getting used to. Just remember that the strength of a price move up or down is always recorded by a peak in the respective DMI line.
Reading directional signals is easy. When the -DMI is dominant and rising, price direction is down. But the strength of price must also be considered. DMI strength ranges from a low of 0 to a high of The higher the DMI value, the stronger the prices swing.
DMI values over 25 mean price is directionally strong. DMI values under 25 mean price is directionally weak. DMI Momentum The great feature of DMI is the ability to see buying and selling pressure at the same time, allowing the dominant force to be determined before entering a trade.
The relative strength of the DMI peaks tells the momentum of price and provides timely signals for trading decisions. This is seen in a strong uptrend.
In this case, the trend will be down. The ability of price to trend depends on continued strength in the dominant DMI. The opposite is true for strong downtrends. When both DMI lines are below 25 and moving sideways, there is no dominant force and trend trades are not appropriate.
However, the best trends begin after long periods where the DMI lines cross back and forth under the 25 level. An important concept of DMI pivots is they must correlate with structural pivots in price. The correlation between DMI pivots and price pivots is important for reading price momentum. Many short-term traders watch for the price and the indicator to move together in the same direction or times they diverge. Conversely, a new pivot low combined with a new high on the -DMI is used to confirm a downtrend.
This is generally a signal to trade in the direction of the trend or a trend breakout. Divergence, on the other hand is when the DMI and price disagree , or do not confirm one another. Divergence is generally a warning to manage risk because it signals a change of swing strength and commonly precedes a retracement or reversal. Price goes through repeated cycles of volatility in which a trend enters a period of consolidation and then consolidation enters a period of trend.
When price enters consolidation, the volatility decreases. Buying pressure demand and selling pressure supply are relatively equal, so the buyers and sellers generally agree on the value of the asset. Once price has contracted into a narrow range, it will expand as the buyers and sellers no longer agree on price. Supply and demand is no longer in balance and consolidation changes to trend when price breaks below support into a downtrend or above resistance into an uptrend.
Volatility increases as price searches for a new agreed value level. Volatility cycles can be identified by comparing the slopes of the DMI lines that move in opposite directions whenever range expansion or contraction occurs Figure 4. Many short-term traders will look for periods when the DMI lines move away from one another and volatility increases. The farther the lines separate, the stronger the volatility. Contractions occur when the lines move toward one another and volatility decreases.
Contractions precede retracements, consolidations or reversals. Before using any indicator, always look at price. Price is trending up when there are higher pivot highs and higher pivot lows. Lower pivot highs and lower pivot lows signify a downtrend. When the -DMI peaks make higher highs, the bears are in control and selling pressure is getting stronger. The best trading decisions are made on objective signals and not emotion. Let price and DMI tell you whether to go long or to go short or just stand aside.
You can use DMI to gauge the strength of price movement and see periods of high and low volatility. DMI contains a wealth of information that can identify the correct strategy for profit whether you are a bull or bear. Dictionary Term Of The Day. A conflict of interest inherent in any relationship where one party is expected to Broker Reviews Find the best broker for your trading or investing needs See Reviews. Sophisticated content for financial advisors around investment strategies, industry trends, and advisor education.
A celebration of the most influential advisors and their contributions to critical conversations on finance. Become a day trader. The calculations for DMI are complicated and are referenced elsewhere. DMI is weak at Point 1 and price is choppy. Note the absence of any crossover by -DMI during the uptrend.
This is generally a signal to trade in the direction of the trend or a trend breakout Divergence, on the other hand is when the DMI and price disagree , or do not confirm one another. The first expansion at Point 1 is part of the downtrend. The subsequent contraction at Point 2 leads to a reversal that begins with another expansion at Point 3. The next contraction at Point 4 leads to a consolidation in price. A conflict of interest inherent in any relationship where one party is expected to act in another's best interests.
Passive investing is an investment strategy that limits buying and selling actions. Passive investors will purchase investments How much a fixed asset is worth at the end of its lease, or at the end of its useful life. If you lease a car for three years, A target hash is a number that a hashed block header must be less than or equal to in order for a new block to be awarded. No thanks, I prefer not making money. Get Free Newsletters Newsletters.More...