Forex trading is a complex and challenging field that requires the use of sophisticated tools and strategies to achieve positive trading results.
One such tool is the directional movement system (DMS), which has been widely adopted by forex traders as a means of identifying market trends and making profitable trades.
In this article, we will explore the origins of the directional movement system, how it works, and examples of its use in forex trading.
Origins of the Directional Movement System
The origins of the Directional Movement System
The directional movement system was developed by J. Welles Wilder in 1978 as a means of identifying the strength of market trends. Wilder, a trader and author of several books on technical analysis, is best known for his development of the relative strength index (RSI) and the average true range (ATR), both of which are widely used by forex traders today.
The directional movement system is based on the concept of directional movement, which is defined as the difference between the current high and the previous high or the current low and the previous low. This concept is used to determine the strength of market trends by calculating the average directional movement over a given period of time.
The DMS is made up of two components, the positive directional indicator (+DI) and the negative directional indicator (-DI), both of which are used to identify market trends. The +DI measures the strength of upward movements in price, while the -DI measures the strength of downward movements. These indicators are plotted on a chart and can be used to generate trading signals.
How the Directional Movement System Works
The directional movement system is based on a set of rules that are used to identify market trends and generate trading signals. The first step in using the DMS is to calculate the true range (TR), which is the greatest of the following:
The difference between the current high and the current low
The absolute value of the difference between the current high and the previous close
The absolute value of the difference between the current low and the previous close
Once the true range has been calculated, the next step is to calculate the directional movement (DM) for the current period, which is defined as follows:
Upward DM = current high – previous high
Downward DM = previous low – current low
The next step is to calculate the average directional movement (ADM) over a given period of time, typically 14 periods. This is done by calculating the sum of the positive and negative DM over the specified period and dividing by the true range. The result is then multiplied by 100 to obtain the +DI and -DI values.
Once the +DI and -DI values have been calculated, they can be plotted on a chart to identify market trends. A bullish trend is indicated when the +DI is above the -DI, while a bearish trend is indicated when the -DI is above the +DI. The degree of separation between the +DI and -DI can be used to determine the strength of the trend.
Examples of how to use the Directional Movement System
The directional movement system can be used in a variety of ways to generate trading signals and identify market trends. Here are a few examples:
Identifying Trend Reversals
One of the key uses of the DMS is to identify trend reversals. When the +DI and -DI are close together, it indicates that the market is range-bound and there is no clear trend.
However, when the +DI and -DI begin to diverge, it is a sign that a trend may be forming. When the +DI crosses above the -DI, it is a bullish signal, indicating that a new uptrend may be beginning. Conversely, when the -DI crosses above the +DI, it is a bearish signal, indicating that a new downtrend may be beginning.
Identifying Entry and Exit Points
The directional movement system can also be used to identify entry and exit points for trades. When the +DI is above the -DI and the trend is bullish, it may be a good time to enter a long position. Conversely, when the -DI is above the +DI and the trend is bearish, it may be a good time to enter a short position. The degree of separation between the +DI and -DI can be used to determine the strength of the trend and the potential for profitability.
Setting Stop Loss and Take Profit Levels
The directional movement system can also be used to set stop loss and take profit levels for trades. When entering a trade, a stop loss order can be placed below the recent low for a long position, or above the recent high for a short position. Take profit levels can be set based on the degree of separation between the +DI and -DI, as well as previous support and resistance levels.
Confirming Other Technical Indicators
The directional movement system can also be used to confirm other technical indicators. For example, if the RSI is showing an oversold condition, but the +DI is above the -DI and the trend is bullish, it may be a good time to enter a long position. Conversely, if the RSI is showing an overbought condition, but the -DI is above the +DI and the trend is bearish, it may be a good time to enter a short position.
Limitations of the Directional Movement System
While the directional movement system can be a powerful tool for forex traders, it is not without limitations. One of the key limitations is that it is a lagging indicator, which means that it may not be effective in predicting future market trends. In addition, the DMS can produce false signals during periods of volatility or when the market is range-bound.
Another limitation of the DMS is that it is a technical indicator and does not take into account fundamental factors that can influence market trends. For example, a sudden change in economic policy or a major geopolitical event may have a significant impact on market trends, which may not be reflected in the DMS.
Conclusion
The directional movement system is a valuable tool for forex traders who are looking to identify market trends and make profitable trades. Developed by J. Welles Wilder in 1978, the DMS is based on the concept of directional movement and is made up of the +DI and -DI indicators, which are used to identify upward and downward movements in price.
The DMS can be used in a variety of ways to generate trading signals, identify trend reversals, and set stop loss and take profit levels. However, it is not without limitations, including its lagging nature and its inability to account for fundamental factors that may influence market trends.
Ultimately, the effectiveness of the DMS will depend on a trader’s ability to interpret the signals it generates and to use it in conjunction with other technical and fundamental indicators. With the right knowledge and experience, however, the directional movement system can be a powerful tool for achieving positive trading results in the forex market.