Trend Detector

ADX Directional Movement Index

DMI indicates when a trend is present and the overall strength of a market.

Overview

  • The higher the DMI (on a scale of 0-100) the better the trend potential of a move.
  • The DMI system is made up of three lines; ADX and +DI & -DI.
  • DMI can be used either as a system on its own or as a filter for a trend-following indicator (i.e., Parabolic SAR).

The Directional Movement Index, DMI, is an effective and frequently used trend indicator. This system was designed by Welles Wilder Jr. and is made up of three lines:

  1. The +DI indicates the up average.
  2. The -DI indicates the down average.
  3. The ADX, average directional movement index, shows whether a trend is in effect by smoothing the difference between the +DI and -DI.

In the example above two clear buy signals have been generated. The first could have been ignored because ADX was very close to 25 – a potential danger signal. The second was perhaps more significant, even though ADX was trending downwards. It did provide a clear indication of the beginning of a very strong move in this market.

Buy and sell signals are given when +DI and -DI cross. The time periods most commonly used in the complex formula are 10 or 14 days.

According to Wilder the DMI should be used with the ADX as a filter.

  • A rising ADX line means the market is trending and a better candidate for a trend-following system.
  • A falling ADX line indicates a non-trending market.
  • Some traders also look for an ADX greater than 20 or 25 to confirm that the market is trending. When the ADX line starts to drop from above the 40 level, that is an early sign that the trend is weakening. A rise back above 20 is often a sign of the start of a new trend.

Signals

Generally speaking, the two main buy and sell signals generated by DMI are as follows:

  • A buy signal is given when +DI crosses above the -DI line.
  • A sell signal is given when +DI crosses below the -DI line.

However, some refinements are suggested by experienced traders:

  • The crossing of DI lines only provides an early warning signal; other criteria must be fulfilled for the actual signal.
  • The ADX should be between the upper DI line and the lower one.
  • An ADX below 25 is a strong warning to avoid trading.

Wilder himself developed a refinement to take care of whipsawing (when the DI lines cross back and forth over a short period, providing unreliable signals). He called it his Extreme Point Rule.

The Extreme Point Rule is derived by noting the high or low point on the day when the +DI and the -DI cross one another. +DI determines the high or low point (if +DI is above -DI the Extreme Point is the high of the day, if +DI is below -DI, the Extreme Point is the low for the day).

The extreme point is then used for the actual buy or sell signal. For example, if the price once again rises above the Extreme Point price level you have a buy signal. If the price fails to rise above the extreme point, you should continue to stand aside. The converse holds true for sell signals.

ADXR

An additional indicator, the average directional movement index rating (ADXR), was created by Wilder as a measuring tool for the strength of ADX. ADXR is the average of the current ADX and the ADX 14 days ago. ADXR is typically plotted alongside ADX on the same chart.

Parabolic SAR

Parabolic SAR provides a useful tool for catching new trends early, offering excellent buy and sell signals.

Overview

  • The Parabolic SAR (stop and reverse) is a trend-following system that sets « stop-losses. »
  • It works well in trending markets, but tends to whipsaw during non-trending, sideways phases.
  • A parabola below the price is generally bullish.
  • A parabola above the price is generally bearish.

The Parabolic System, developed by Welles Wilder who also developed the Relative Strength Index (RSI), is usually referred to as the Parabolic « SAR » (stop-and-reverse). Mr Wilder designed this indicator to supplement the other trend-following systems.

The Parabolic SAR is a « stop-loss » system used to set trailing price stops. The name of the system is derived from its parabolic shape, which follows the price movements in the form of a dotted line. When the parabola follows along below the price, the trader should be buying or going long. A parabola above the price suggests selling or going short.

The particular value of the Parabolic SAR is that it allows traders to catch new trends relatively early. If the new trend fails, the parabola quickly switches from one side of the price to the other, thus generating the stop and reverse signal.

Mr. Wilder built an acceleration factor into the Parabolic system. To allow the trend time to become established, the movement of the indicator starts off slowly – with the dots close together. As acceleration increases, the parabola move faster (with the dots further apart) until it catches up to the price action.

As with most indicators, Parabolic SAR performs best in trending markets, and is less reliable during sideways or congestive phases.

Signals

The Parabolic SAR is an outstanding indicator for providing exit points – offering sell signals when the parabola moves above the price. Buy signals are generated when the parabola falls below the price. Of course, these signals need to be confirmed by the price action itself and other, complementary indicators.

It is always useful to examine different time periods; using daily, weekly and monthly charts.

Combining Parabolic SAR with DMI

John Murphy, author of Technical Analysis of the Financial Markets, recommends using a filter to complement the Parabolic system. He suggests using the Directional Movement Index (DMI) to help eliminate whipsaws and false signals in the more sensitive Parabolic system. As a simple rule of thumb, he observes that the DMI and Parabolic SAR indicators can complement one another as follows: « When the +DI line is above the -DI line, all Parabolic sell signals can be ignored. » We can see the effectiveness of this strategy below. (The ADX line is essentially the smoothed difference between the +DI and -DI lines.)


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