Directional Movement Index (DMI) Trading Strategy (Backtest)

The DMI trading strategy is often known on most trading platforms by its third component, the average directional index (ADX). Not many know what the DMI is. Let’s take a look at it.

The DMI (directional movement index) is a trend indicator that shows the strength of a trend, irrespective of the direction. It has two main components: a positive directional movement line (+DI), which measures the changes in price high, and a negative directional movement line (-DI) which tracks the price lows. There is also an optional third line, the ADX line, which can also be used to gauge the strength of the uptrend or downtrend.

This article explains the DMI and at the end, we do a backtest to find out if you can use the DMI to make a trading strategy.

What is the DMI trading strategy?

The DMI (directional movement index) is a trend indicator that shows the strength of a trend, irrespective of the direction. It has two main components: a positive directional movement line (+DI), which measures the changes in price high, and a negative directional movement line (-DI) which tracks the price lows.

The two components are used to gauge the strength of the uptrend or downtrend. They can be used to differentiate between strong and weak trends, so traders use the indicator to formulate momentum-based trading strategies. The indicator works on all time frames and can be used to trade any asset, including stocks and futures. While the indicator assists in determining if a security is trending and attempts to measure the strength of the trend, it disregards the direction of the security. It only attempts to determine if there is a trend and the strength of the trend.

In some platforms, the indicator is made up of four indicator lines:

1. Positive directional movement indicator (+DMI): This shows the difference between today’s high price and yesterday’s high price. A 14-period value is used to get the +DMI line.
2. Negative directional movement indicator (–DMI). This shows the difference between today’s low price and yesterday’s low price, but the values are then summed up from the past 14 periods and plotted.
3. Average Directional Index (ADX). This is a smoothing of the DX, which measures the difference between the +DMI and -DMI
4. Average Directional Movement Index Rating (ADXR): This is a simple average of today’s ADX value and the ADX from 14 periods ago.

When the levels of the ADX and ADXR are high and rising, it indicates a strong trend, either up or down. Typically, an ADX value of 25 is used as the threshold for a strong trend — if the ADX is above 25 it indicates a strong trend. On the flip side, low and falling levels of the ADX and ADXR indicate a trendless market. When the ADX is below 20 it indicates a trendless market (according to the theory).

What is the formula for DMI (trading strategy)?

The formulas for the directional movement index are given as follows:

+DMI = {Smoothed +DM/ATR} x 100

-DMI = {Smoothed -DM/ATR} x 100

DX = [(+DMI — -DMI)/(+DMI + -DMI)] x 100

Where:

+DM (Directional Movement) = Current High — Previous High

-DM = Current Low — Previous Low

ATR = Average True Range

Note that the +DM and -DM are smoothed over 14 periods. Also, note that the ADX is a smoothed version of the DX. To get the ADXR, you calculate a simple average of today’s ADX value and the ADX from 14 periods ago.

Who invented the DMI?

The DMI (trading strategy) and other components were invented in the 1970s (most likely 1978) by an American technical analyst, J. Welles Wilder, who is widely known for authoring “New Concepts in Technical Trading Systems” and developing the ever-popular RSI indicator.

What does the DMI tell you?

The DMI tells you the momentum of the price action — when +DMI is above -DMI, there is more upward pressure than downward pressure in the price, and when -DI is above +DI, there is more downward pressure on the price. Thus, the indicator can be used to identify or confirm a trend. If the +DMI is well above -DMI, the trend has strength on the upside. Conversely, if -DMI is well above +DMI, it indicates a strong downtrend.

This indicator may also help traders determine the direction to trade, as crossovers between the lines are also sometimes used as trade signals to buy or sell. A long trade is taken when the +DMI crosses above the -DMI and an uptrend could be underway. On the other hand, a sell signal occurs when the +DMI instead crosses below the -DMI. In such cases, a short trade may be initiated because a downtrend might be underway.

DMI indicator vs ADX indicator

DMI (Directional Movement Index) and ADX (Average Directional Index) are tools that help people who trade stocks or other things figure out if a price trend is strong and which way it’s going.

• DMI has two lines: +DI and -DI. +DI shows if prices are going up strong, and -DI shows if prices are going down strong. If +DI is higher, it means prices are going up, and if -DI is higher, it means prices are going down.
• ADX is one line that tells you how strong the trend is, but it doesn’t say if prices are going up or down. A high ADX means a strong trend, and a low ADX means a weak or sideways trend.

People use these tools to decide when to buy or sell thing

As mentioned, the DMI is part of the ADX indicator.

We consider the ADX indicator to be a very underappreciated indicator and one of the most valuable indicator ever made. However, it doesn’t work so well on it’s own but must be used with other parameters. Furthermore, it doesn’t work so well in the “traditional” way as explained in the original book by Welles Wilder or shown on most websites. We use the ADX frequently among our monthly trading edges.

DMI trading strategy backtest

Let’s go on to backtest the DMI trading strategy and potentially find a trading strategy or strategies. We can reveal from the start that DMI doesn’t work on its own (both DMI+ and DMI-) – just like the ADX indicator.

As usual, we did a twist to the DMI indicator to improve the result. Below we have a backtest and strategy on S&P 500 (SPY) that uses the DMI+ and another variable. The equity curve looks like this:

The number of trades since SPY’s inception in 1993 is 382, the average gain per trade is 0.55%, the win rate is 76%, the max drawdown is a modest 14%, and the profit factor is 2.6. We would say this is a pretty solid strategy and is unlikely to be a result of curve fitting.

We keep the trading strategy for our paying subscribers of monthly trading edges.

DMI (directional movement index) – ending remarks

The ADX indicator is not a stand-alone indicator, and so is the DMI. It requires some boost from other variables. However, it’s pretty powerful if you use it correctly!

What is the DMI (Directional Movement Index) Trading Strategy?

The DMI Trading Strategy is a trend indicator that measures the strength of a trend, regardless of its direction. It comprises two main components: the positive directional movement line (+DI) and the negative directional movement line (-DI), which help traders assess the strength of uptrends and downtrends.

How does the DMI differ from other trend indicators?

Unlike many trend indicators, the DMI focuses on gauging the strength of a trend without considering its direction. It helps traders identify strong and weak trends, providing valuable insights for formulating momentum-based trading strategies.

What are the key components of the DMI (Directional Movement Index)?

The DMI has three main components: +DI (positive directional movement line), -DI (negative directional movement line), and the optional ADX (Average Directional Index). These components work together to assess trend strength and differentiate between strong and weak trends.

Directional Movement Index (DMI) Glossary

1. ADX (Average Directional Index): A technical indicator used to measure the strength of a trend.
2. Aroon: A pair of indicators, Aroon Up and Aroon Down, used to identify the strength and direction of a trend.
3. ATR (Average True Range): A volatility indicator that measures market volatility.
4. Bearish: A market sentiment indicating an expectation of price decline.
5. Bullish: A market sentiment indicating an expectation of price increase.
6. CCI (Commodity Channel Index): An oscillator used to identify overbought and oversold conditions.
7. Crossover: When two DMI lines cross each other, often signaling a trend change.
8. Divergence: When price movement and DMI direction move in opposite directions.
9. DMI (Directional Movement Index): A technical indicator used to assess the strength and direction of a trend.
10. EMA (Exponential Moving Average): A type of moving average that gives more weight to recent prices.
11. False Signal: A signal generated by DMI that doesn’t result in a significant price move.
12. Fibonacci Retracement: A technical analysis tool used to identify potential support and resistance levels.
13. Gap: A discontinuity in price levels on a chart.
14. Golden Cross: A bullish signal when a short-term moving average crosses above a long-term moving average.
15. Hedging: A strategy to minimize risk by taking offsetting positions.
16. Ichimoku Cloud: A comprehensive indicator used for trend analysis.
17. Intraday: Within the same trading day.
18. Lagging Indicator: A technical indicator that follows price action.
19. Leading Indicator: A technical indicator that predicts future price movements.
20. Leverage: The use of borrowed funds to increase trading position size.
21. Long Position: Buying an asset with the expectation that its price will rise.
22. MACD (Moving Average Convergence Divergence): A trend-following momentum indicator.
23. Margin Call: A demand from a broker to deposit additional funds to cover trading losses.
24. Market Order: An order to buy or sell at the current market price.
25. Moving Average: A calculation of average prices over a specific period.
26. OBV (On-Balance Volume): A volume-based indicator used to predict price movements.
27. Overbought: A condition when an asset’s price has risen too rapidly and may reverse.
28. Oversold: A condition when an asset’s price has fallen too rapidly and may reverse.
29. Pip: The smallest price move that a given exchange rate can make.
30. Range: The difference between the highest and lowest prices during a specific period.
31. Resistance: A price level where selling pressure may increase.
32. RSI (Relative Strength Index): A momentum oscillator used to identify overbought and oversold conditions.
33. Scalping: A short-term trading strategy aiming for small profits.
34. Short Position: Selling an asset with the expectation that its price will fall.
35. Trend Strength Trading: Focuses on measuring the strength of market trends and using this information to identify potential trading opportunities.
36. Directional Indicator Trading: Relies on directional indicators like the DMI to determine the prevailing trend and initiate trades in that direction.
37. DMI-Based Trading Approach: A trading strategy that heavily incorporates the Directional Movement Index as a key component for decision-making.
38. Trend Momentum Strategy: Capitalizes on price momentum within established trends to enter and exit trades for profit.
39. Directional Movement Trading System: A systematic approach that relies on the directional movement of asset prices to guide trading decisions.
40. Price Trend Index (PTI) Strategy: Incorporates a Price Trend Index to identify and follow market trends effectively.
41. Trend Identification and Confirmation Method: An approach that focuses on both identifying and verifying trends before executing trades.
42. Directional Momentum Trading: Combines directional signals and momentum indicators to make informed trading choices.
43. Price Direction Assessment Strategy: The strategy emphasizes assessing the direction of price movement before committing to trading positions.
44. Stop Loss: An order to limit potential losses by selling or buying an asset at a specific price.
45. Support: A price level where buying pressure may increase.
46. Swing Trading: A trading strategy that aims to capture price swings within a trend.
47. Trend Line: A line drawn on a chart to represent the direction of a trend.
48. VIX (Volatility Index): A measure of market volatility often referred to as the “fear index.”
49. DMI Indicator: A technical analysis tool that helps traders identify the strength and direction of a trend in financial markets.
50. Directional Movement System: A trading strategy based on the DMI indicator to determine market trends and potential entry or exit points.
51. Trend Strength Indicator: An indicator like DMI used to assess the strength of a price trend in a financial instrument.
52. ADX (Average Directional Index): A specific component of the DMI system that quantifies the strength of a trend.
53. Directional Indicator: Any tool that provides information on the direction of price movements in a market, like the DMI.
54. Directional Trend Analysis: The process of analyzing price trends and market direction using DMI and related techniques.
55. DMI Oscillator: A variation of DMI that transforms the indicator into an oscillator, helping traders identify overbought or oversold conditions.
56. ADXR (Average Directional Movement Rating): An extension of DMI that combines multiple timeframes to assess the overall trend strength.
57. Wilder’s DMI: A reference to J. Welles Wilder Jr., who developed the DMI indicator.
58. Directional Movement Trading: A trading approach centered around the use of DMI or similar indicators to make directional bets.
59. Directional Trend Momentum: A strategy that combines momentum and trend analysis using DMI.
60. ADI (Average Directional Index): Another term used interchangeably with ADX, referring to the same component of the DMI system.
61. Directional Movement Strategy: A trading plan that incorporates DMI to make informed trading decisions.
62. Trend Analysis with DMI: The practice of studying price trends while relying on the insights provided by DMI.
63. DMI Crossover Strategy: A trading approach that involves interpreting crossovers between different components of the DMI indicator to trigger buy or sell signals.
64. Volume: The number of shares or contracts traded in a security or market during a given period.
65. Wedge Pattern: A chart pattern indicating a potential trend reversal.
66. Whipsaw: A situation where a trader gets caught in a series of losing trades due to rapid market reversals.
67. Yield: The return on investment in percentage terms.
68. Zigzag Indicator: A tool used to identify potential reversals in a price trend.