Directional Movement

Many traders believe in the importance of the trend and consequently include some trend following component in their trading system. The Directional Movement indicators measure the strength of a prevailing trend as well as whether movement exists in the market. Consequently, the directional movement system is best used for either of the following:

• As a stand alone trend following system, or
• To determine if a stock is trending or not; and if so, employ other trend following indicators.

There are actually 3 parts which make up the directional movement indicators. These are the Directional Movement Index (DX); the plus Directional Indicator (+DI); and the minus Directional Indicator (-DI). To determine the values for the three lines in the directional movement system, the actual directional movement (DM) must first be calculated.

It’s important to note that the DM can be either negative or positive, and is labelled +DM and –DM accordingly. The DM is calculated by determining whether the larger part of today’s range is above or below yesterday’s range. If it is above, then +DM will be used and if below, -DM will be used.

The directional indicator (DI) is then determined by dividing the DM by the true range for the day. This is then multiplied by 100 to arrive at a percentage value. The Directional Movement Index (DX) is then calculated by taking the difference between the +DI and the –DI and dividing it by the sum of the +DI and the –DI. This resultant number is then expressed as a percentage.

The interpretation is such that, the higher the value of the DX, the more directionality the security is presently experiencing, either up or down, and therefore the stronger the trend. This is a key strength in the directional movement indicators. Understanding how they are calculated is not as important as understanding how to employ them.

The directional movement system is displayed on charts with three main indicators, i.e. the +DI, the –DI and the DX lines. They would look similar to the lines below. Note that the main DX line is the thick black line.

A basic trading system involves first identifying that a security is trending, indicated by the DX line moving upwards. Then the +DI (green) and the –DI (red) are plotted on top of each other. When the +DI rises above the -DI, it is a bullish sign; and a bearish signal occurs when the +DI falls below the -DI.