The Directional Movement system helps identify trends and whether or not price is moving quickly enough to be worth a long or short play. Developed by Welles Wilder and explained in his book, New Concepts in Technical Trading Systems, it can be used either as a system on its own or as a filter on a trend-following system.
It involves 5 indicators: the plus Directional Indicator (+DI), the minus Directional Indicator (-DI), the Directional Movement Index (DX), the Average Directional Movement (ADX) and the Average Directional Movement Rating (ADXR).
+DI and -DI are components in the calculation of the other three indicators. The first line measures positive (upward) movement and the second number measures negative (downward) movement. A buy signal is given when the +DI line crosses over the - DI line while a sell signal is generated when the +DI line crosses below the - DI line.
In addition to these crossover rules, Wilder believes one should also follow the extreme point rule. When a crossover occurs, use the extreme price as the reverse point. For a short position, use the high made during the trading interval of the crossover. Reverse a long position using the low made during the trading interval of the crossover.
The Directional Movement Index (DX) is the ratio of the difference between +DI and -DI to the sum of them. It oscillates between ‘0’ and ‘100’. Readings above ‘60’ is very rare. High readings show a strong trend.
The Average Directional Index (ADX) is simply a modified moving average of DX. It quantifies the strength and the direction of a trend. You can read the ADX like an oscillator. A high positive value would be bullish. A low negative value is interpreted as bearish.
The Average Directional Index Rating (ADXR) is an attempt to quantify momentum change in the ADX. It is calculated by adding the current ADX value and an ADX value n periods back then dividing that sum by two. This smoothing step results in the ADXR being slightly less responsive than the ADX. Where the ADXR shines is its ability to compensate for the variance of excessive tops and bottoms. It is especially helpful when used in conjunction with trend-following strategies.
In his book Wilder says, "as a rule of thumb, the system will be profitable on commodities that have a CSI value above 25. When the CSI drops below 20, then do not use a trend-following system."
Calculation:
DeltaH = High – PrevHigh
DeltaL = PrevLow – Low
If (DeltaH<0 and DeltaL<0) OR DeltaH= DeltaL then
+DM = 0, -DM = 0
If DeltaH>DeltaL then
+DM = DeltaH, -DM = 0
If DeltaH<DeltaL then
+DM = 0, -DM = DeltaL
WWMA = Welles Wilder’s Moving Average (Wilder’s Smoothing)
Inputs:
Period = 14
Indicates time period(the number of days for daily analysis, the number of weeks for weekly analysis, etc.).
Indicator Type: Trend