Directional Movement System

[Leth]

Directional Movement
by Welles Wilder

The Directional Movement System is a fairly complex indicator developed by Welles Wilder and explained in his book, New Concepts in Technical Trading Systems.

Most indicators have one major weakness - they are not suited for use in both trending and ranging markets. The key feature of the Directional Movement System is that it first identifies whether the market is trending before providing signals for trading the trend.

Directional Movement System measures the ability of bulls and bears to move price outside the previous day's trading range. The system consists of three lines:

-The Positive Direction Indicator (+DI) summarizes upward trend movement;
-The Negative Direction Indicator (-DI) summarizes downward trend movement; and
-The Average Directional Movement Index (ADX) indicates whether the market is trending or ranging.

Welles Wilder does not use the standard moving average formula. This should be taken into account when selecting indicator time periods.

Trading Signals

A number of different trading systems have developed around Directional Movement. The following rules are based on the system presented by Dr Alexander Elder in Trading for a Living:

-Go long when +DI is above -DI and either:
ADX rises while +DI and ADX are above -DI; or
ADX turns up from below +DI and -DI.
-Exit when +DI crosses below -DI.

-Go short when -DI is above +DI and either:
ADX rises while -DI and ADX are above +DI; or
ADX turns up from below +DI and -DI.
-Exit when -DI crosses below +DI.

Use stop loss orders at all times.

ADX:

Declining ADX shows that the market is losing direction. When ADX falls below both +DI and -DI it signals a lifeless market. Do not trade with DMS until ADX has clearly turned off the bottom. Dr Elder suggests waiting until ADX rises 4 steps off its low (e.g. ADX rises to 19 from a low of 15). The longer that ADX has remained below both +DI and -DI the stronger the subsequent trend is likely to be.

When ADX rises above both +DI and -DI it signals that the market is becoming overheated. Take profits when ADX turns downwards from above +DI and -DI.

Example

The Commonwealth Bank of Australia Limited is plotted with 14-day +DI, -DI and ADX.

cba%20dms.png

1. -DI crosses to above +DI so trade only short.
2. Go short when ADX rises above +DI.
3. Take profits when ADX turns down while above +DI and -DI.
4. Exit short trade and trade only long as +DI has crossed to above -DI.
5. Go long as ADX starts rising while above -DI.
6. Take profits when ADX turns down while above +DI and -DI.
7. Exit long trade and trade only short as -DI has crossed to above +DI.
ADX continues to fall so there are no trades.
Trade only long as +DI has crossed to above -DI.
ADX turns up while below +DI and -DI, but does not rise by the recommended 4 steps, so no trade is entered.
8. One view is that you should go long whenever ADX rises above -DI, but ADX has remained very low and flat and it would be advisable not to trade until ADX has risen by at least 4 steps above its recent low.
9. Trade only long as +DI has crossed to above -DI.
10. Go long when ADX rises above -DI.
11. Exit long trade when +DI falls below -DI.

Setup

The default Directional Movement System uses 14 day smoothing. This is not equivalent to a 14 day EMA.