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Directional Movement Index (DMI): When a Market Starts/Stops 'Trending'

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My 'mailbag' this week included the following e-mail note: "You discussed in your weekend index column how the strong upward trend has been flattening out lately. I recall that there's some indicator that measures trend direction and strength. is this telling us anything recently?"

RESPONSE: I did discuss in my most recent Index Trader how the uptrend line/uptrend channels were intact in the broader measures of the market, namely the S&P 500 (SPX) and the Nasdaq Composite (COMP), but that the trend was starting to go more sideways in some of the narrower big cap stock indexes, namely the S&P 100 (OEX) and the Dow 30 (INDU). This is not so in the Nasdaq 100 (NDX), which is also maintaining its uptrend. By 'maintaining' an uptrend, I mean that the rising trendlines have NOT been pierced by a fall to below those lines, especially on a closing basis. However, the rate of upward momentum can slow significantly even though the dominant rising/up trendlines are intact.

Before I launch into a discussion of the indicator I'm sure you're referring to, the Directional Movement Index or DMI for short, I'll just mention that my last 'Index Trader' column (12/2) titled 'Slowing Upside Momentum', can be seen on the Option Investor Daily.com web site by clicking here (if connected online).

A well-known trader and inventor of some technical formulas relating to market trends, Welles Wilder, came up with several technical indicators that remain in widespread use. Most of his indicators, while developed in the commodities futures markets, are also relevant to stocks and stock indexes. A market is a market basically, rather in foreign exchange (FOREX), commodities or stock market instruments.

In most periods or on average, a market is in a strong/dominate up or down trend only a minority of days, weeks or months of the year. In Wilder's experience, most markets only trended strongly about a third of the time. The rest of the time there are a lot of minor ups and downs and there's a tendency for many back and forth price swings, which result in 'whipsaw' trends and trades.

The whipsaw periods are when the use of a 21-day moving average for the major market indexes like the S&P 500 (SPX), coupled with 3 percent moving average envelopes, 'work' fairly well in suggesting where to enter calls or puts. Dips of 3 percent under the 21-day moving average in broad sideways trends will often be areas that favor call purchases and rallies to 3 percent or so above the 21-day average will tend to be the upper trading extremes for major stock market indexes like the S&P 500, 100 and the Dow; a move to the upper envelope lines suggest potential put opportunities. With the Nasdaq, the moving average envelope extremes tend toward 4-5 percent.

Obviously the steady price advance of the last several months has been an example of a strongly trending market. In order to provide a statistical 'model' for the point when a market or stock can be said to begin trending strongly up or down, Wilder came up with a Directional Movement Index (DMI) indicator. The Dow 30 average's (INDU) daily chart below has the Directional Movement Index or DMI indicator 'applied' to it, with the DMI's 3 components of ADX, DMI plus and DMI minus which are labeled as DMI+ (or DI+) and DMI- (sometimes called just DI-). Most charting programs or sites will have the 'DMI' among their indicators:

1. ADX provides an indication of HOW MUCH directional movement (trend) is present in a market and provides a way to compare the trend in different markets. Sometimes a separate indicator called 'ADXR' rates the directional movement for a market on a scale of 0 to 100; however, we see this same scale on the right hand side of the ADX indicator below. For a major stock market index like SPX, an ADX reading above 40 shows a very strong trend. Volatile commodity markets can see ADX reach 70 or above. An ADX line below 20 is usually defined as a 'non-trending market.
2. DMI plus or DMI+ is a measure of positive or upward movement.
3. DMI minus or DMI- measures downward movement and its intensity.

The rising ADX line seen above, as suggested by the dashed (black) up trendline from August until its recent (late-November) downturn, is simply a mathematical way of showing a strong uptrend; the same is seen in the rising price trendline that connects the various reaction lows of INDU and seen above the DMI indicator. When the ADX line turns DOWN (as seen above) for a period of a few days to a couple of weeks, it is showing a trend that is the process of eroding on an intermediate-term basis.

To generate a buy or sell 'signal' of a certain 'threshold' trend strength, the DMI+ line must cross ABOVE the DMI- line or vice-versa; the DMI+ line crosses BELOW the DMI- line. This can happen for just brief periods such as occurred around mid-August, only to see the DMI+ line flip back above the DMI- line.

The recent sideways trends in DMI+ and DMI- also as seen above are suggesting the same thing as the recent downtrend in ADX except that the sideways movement is showing us that there is not yet enough of a price decline for DMI+ to cross BELOW DMI- and generate a sell 'signal'. The value of such a study or indicator is that it gives you some confirmation of a trend direction of sufficient intensity to provide some technical 'confirmation' that the trend has shifted in the favor of a trade you've already entered or are thinking of entering; or of course, the DMI+/DMI- crossover direction might warn you off from or OUT of a trade you're already in.

Since the basic directional movement 'system' is to buy on an upside or downside DMI+/DMI- 'crossover', there is of course the pitfall of getting 'whipsawed' in a crossover of a short duration.

Wilder qualified the crossover 'system' with a simple 'extreme point (trading) rule' which would have prevented entry on the short (put) side of DJX puts back in the short-lived downside DMI+ decline to under the DMI- line; this, back on August 10th. A close up view of this August (downside) crossover will be used below to demonstrate how the 'extreme point rule' would have operated for us.

The extreme point rule requires that on the day that the DMI+ and DMI- lines cross, you should note the 'extreme' point; i.e., either the intraday high in the case of an upside crossover or the intraday low in the case of a downside crossover (of DMI+ below DMI-). When DMI+ rises above the DMI-, the extreme price is that day's high. When DMI+ falls below DMI-, the extreme price is that day's low.

The extreme point is then used as the point at which you should implement the trade. For example, AFTER receiving a buy signal, you should wait until the price NEXT rises above the extreme point. This would have triggered an Index call purchase back in late-July (see below). AFTER receiving a sell signal (DMI+ line crosses below the DMI- line), you would wait until the low of that day is exceeded. The right hand red down arrow on the chart below shows the low the day when a sell 'signal' became in effect. However, the next day's low was not below that extreme.

Actually, the Dow's theoretical low the day after the downside sell 'signal' (on 8/11) was 2 points below the prior days low (of 8/10). Since 2 points is so practically nothing in INDU, it would be better in this kind of situation to check as to what the S&P was doing relative to ITS extreme point.

The low in the S&P 500 (SPX) on August 10th was 1261, so this was the SPX extreme point. SPX's low on the next day of 8/11 was 1262 so the 'extreme point rule' would have suggested NO put trade that day. After August 1lth, the DMI+ line flipped back above the DMI- line and there has not been a downside (sell indication) crossover since then. Therefore, a call purchase in DJX calls has been in ongoing since a price of 111.3; the Dow Index (DJX) closed today of course at 123.

The 'DMI' indicator is worth checking out to provide an indication of the longer-term trends and can be used with weekly charts also. Like any directional movement system there is a danger of getting 'whipsawed' on traders when the DMI+/DMI- upside or downside crossovers are used 'mechanically'. I use it mostly as a confirmation of trend direction and intensity. We can see trend direction shift just by looking at the charts, but the DMI indicator is a good check on what you're seeing in the charts.

GOOD TRADING SUCCESS!

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