DMI — What Is It? (Backtest And Trading Strategy)
Last Updated on October 23, 2022
The DMI 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?
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:
- 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.
- 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.
- Average Directional Index (ADX). This is a smoothing of the DX, which measures the difference between the +DMI and -DMI
- 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?
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 and other components were developed 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.
The ADX indicator
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 backtest and trading strategy
Let’s go on to backtest the DMI 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!