Directional Movement

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Description

The Directional Movement System, developed by J. Welles Wilder, is explained thoroughly in his book, New Concepts in Technical Trading Systems. MetaStock calculates and plots all five of the indicators that comprise the Directional Movement System (i.e., CSI, +DI, -DI, ADX, and ADXR).

MetaStock also calculates a related indicator, the Commodity Selection Index.

Wilder's book gives complete step-by-step instructions (and examples) on calculating and interpreting each of the above indicators.

Interpretation

The basic Directional Movement trading system involves plotting the 14-period +DI and the 14-period -DI on top of each other in the same inner window. An improved method of displaying these two indicators is to plot their difference using the following formula:

pdi(14) - mdi(14)

Positions should be taken by buying when the +DI rises above the -DI (i.e., the formula shown above rises above zero) and selling when the +DI falls below the -DI (i.e., the formula falls below zero).

These simple trading rules are qualified with the "extreme point rule." This rule is designed to prevent whipsaws and reduce the number of trades.

The extreme point rule requires that on the day that the +DI and -DI cross, you note the "extreme price." If you are long, the extreme price is the low price on the day the lines cross. If you are short, the extreme price is the high price on the day the lines cross.

The extreme point is then used as a trigger point at which you should implement the trade. For example, after receiving a buy signal (the +DI rose above the -DI), you should then wait until the security's price rises above the extreme point (the high price on the day that the +DI and -DI lines crossed) before buying. If the price fails to rise above the extreme point, you should continue to hold your short position.

In Wilder's book, he notes that this system works best on securities that have a high Commodity Selection Index (CSI) value. He says, "as a rule of thumb, the system will be profitable on commodities that have an ADXR value above 25. When the ADXR drops below 20, then do not use a trend-following system."