Number 11
Please
note that we have used historical data. These examples
are for educational purposes only.
Directional
Movement System (Wilder)
In this
issue of the ChartFilter newsletter we'll look at
Wilder's Directional Movement system, incorporating
three indicators - Directional Movement Index (DMI),
the Average Directional Index (ADX), and Parabolic
SAR.
The DMI
system is an effective and frequently used trend
indicator. This system was designed by Welles Wilder
Jr. and is made up of three lines:
- The +DI indicates
the up average.
- The -DI indicates
the down average.
- The ADX, average
directional movement index, shows whether a
trend is in effect by smoothing the difference
between the +DI and -DI.
CURRENT
TRENDS - Learning from the Indices
In this
section we'll apply the DMI system to the NASDAQ
and DJIA indices. Since DMI is a trend indicator
it can provides some useful insights into possible
changes in trend. The current short term trend for
both the Dow and the NASDAQ is downwards. However
there are some signs being given by DMI that this
may be changing... let's take a look at the charts.
I've charted
both the NASDAQ and DJIA and drawn trendlines. Both
charts also feature the DMI, ADX and Parabolic SAR
indicators. I've used a six month daily chart in
the case of the NASDAQ, and a one year daily chart
for the DJIA.
With DMI/ADX
I look for a couple of signals:
- when ADX is above
20 it indicates that the underlying stock or
index is trending strongly enough to make a
move in one direction or the other. (ADX is
an indicator of the strength of a trend, not
the direction!) As a simple rule of thumb, I
wouldn't consider buying a stock when the ADX
is below 20 (unless there are very strong overriding
circumstances or I'm interested in a long term
trade and several other indicators are bullish).
- where is the +DMI
line relative to the -DMI line? +DMI should
be above -DMI. A bullish signal is given when
+DMI crosses above -DMI, particularly when ADX
is above 20.
Now combine
this with Parabolic SAR - with this indicator you
have a bullish signal when the parabolic dots switch
from above the price line to below.
Let's consider
the above chart for NASDAQ:
- Parabolic SAR switched
(gave a bullish signal) relatively recently
in early December.
- ADX is above 20
at roughly 35 or so (bullish). However, it is
downtrending, which is not as favourable as
an uptrending ADX. 3.
- +DMI is below -DMI
- and therefore not yet bullish. Consider this
a caution.
You can
see the value of the DMI system above, when you
consider that +DMI (blue) dropped below -DMI (red)
in July and has basically remained there ever since
(other than a brief foray above in early September).
Now let's
take a look at the Dow Jones Industrial Average.
(Remember this is a one year chart, compared to
the six month chart above).
Here's what
the indicators are telling us:
- Parabolic SAR has
recently switched from above the line to below
- once again a bullish signal.
- +DMI (blue) has
also recently crossed above -DMI (red) - another
bullish signal.
- However, ADX (black)
is below 20. Consider this a caution.
Once again
we have a couple of bullish signals, however with
cautions in both cases. So we have the early signs
of a possible switch in short term trend for both
the NASDAQ and the Dow. Keep an eye on these indicators
in the coming days, if the cautions are removed,
we could have the early signs of a trend reversal.
Remember to consider also the trendlines - a further
bullish signal will be given when the top resistance
trendline is broken on the upside.
In addition,
please note the value of ADX in the DJIA chart above.
See how valuable it can be in keeping traders out
of choppy waters? ADX dropped below 30 and then
20 in April. This was the beginning of a very choppy
sideways market for about 4 months. As we've seen
in the past, these choppy markets are very difficult
to trade successfully. In this case ADX would have
done its job by keeping you on the sidelines. When
ADX broke above 20 in August, we began to see more
strongly trending markets with more significant
moves. Once again, let me remind you that ADX signals
the strength of the trend - the direction
of ADX is not related to the direction of the underlying
market. If you have an uptrending ADX line, it is
telling you that the market trend is picking up
strength - the market itself may be headed downwards
or upwards.
And here's
one more quick tip - when ADX is above 20 or 25
and +DMI is above -DMI you can ignore sell signals
given by the Parabolic SAR (when the dots switch
from below the price to above).
TIPS
& TECHNIQUES - Using DMI, ADX and Parabolic SAR
This system
of indicators is one of my favourites!
For detailed
information see the ChartFilter reports on DMI,
ADX and Parabolic
SAR.
There's
lots more to come! Your comments or suggestions
are always welcome; e-mail us at Newsletter@ChartFilter.com.
