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.
The Average True Range (ATR) is a technical indicator that measures the volatility of a financial instrument.
It was developed by J. Welles Wilder Jr. in the 1970s and has since become a popular tool among traders in various financial markets, including Forex and the stock market.
What the ATR indicator shows
The ATR is calculated by taking the average of the true range over a specified number of periods. The true range is the greatest of the following:
The current high minus the current low The absolute value of the current high minus the previous close The absolute value of the current low minus the previous close The ATR is typically presented as a single line on a chart, with the vertical axis representing the ATR value and the horizontal axis representing time. A higher ATR value indicates a higher level of volatility, while a lower ATR value indicates a lower level of volatility.
How the ATR indicator can help you in your trading
One of the main uses of the ATR is to identify periods of high and low volatility in the market. During periods of high volatility, the ATR will be relatively high, indicating that the price of the financial instrument is fluctuating significantly.
Conversely, during periods of low volatility, the ATR will be relatively low, indicating that the price of the financial instrument is not fluctuating as much.
ATR for setting TP and SL levels
Traders can use the ATR to set appropriate stop-loss and take-profit levels in their trades. For example, if the ATR is relatively high, a trader may set wider stop-loss and take-profit levels to account for the increased volatility.
On the other hand, if the ATR is relatively low, a trader may set narrower stop-loss and take-profit levels, as the price is less likely to fluctuate significantly.
ATR used for entry and exit points
In addition to setting appropriate stop-loss and take-profit levels, traders can also use the ATR to identify potential entry and exit points in the market.
For instance, if the ATR is relatively high, it may be a good time to enter a trade, as there is likely to be increased price movement that the trader can capitalize on.
On the other hand, if the ATR is relatively low, it may be a good time to exit a trade, as the price is less likely to fluctuate significantly.
Another way that traders can use the ATR is to confirm trends in the market. If the ATR is consistently increasing, it may be an indication that the current trend is strong and likely to continue.
Conversely, if the ATR is consistently decreasing, it may be an indication that the current trend is losing strength and may be coming to an end.
ATR indicator best practices
It’s worth noting that the ATR is not a standalone indicator and should be used in conjunction with other technical and fundamental analysis tools.
For example, a trader may use the ATR in conjunction with trend indicators such as moving averages or oscillators like the Relative Strength Index (RSI) to get a more complete picture of the market.
In summary, the Average True Range (ATR) is a technical indicator that measures the volatility of a financial instrument.
It is used by traders to set appropriate stop-loss and take-profit levels, identify potential entry and exit points in the market, and confirm trends. While the ATR is a useful tool, it should not be used in isolation and should be combined with other analysis techniques for a more comprehensive approach to trading.
RSI stands for Relative Strength Index, and it has become one of the most popular technical indicators in the trading of stocks and Forex (Foreign Exchange).
Developed by J. Willes Wilder, and published in his 1978 book named New Concepts in Trading Systems, the RSI helps investors detect when prices are potentially overbought or oversold. It is a momentum oscillator, and can be used in trading any equity on financial markets.
Here we see a range bound market, with clearly identifiable support and resistance levels. The trader sees that the asset has moved into overbought territory, then waits for a candle showing bears significantly stronger than bulls. A sell trade is opened. About three weeks later, the same asset is in oversold with RSI lower than 30. The trader opens a buy trade. Both trades turned out to be quite profitable.
The indicator measures both velocity and magnitude of directional price movements. Two parameters can be adjusted. The number of periods, and the level of the RSI itself. The standard settings for the indicator is 14 periods, overbought level to 70, and oversold level to 30.
Common use cases
Although the indicator is mostly used in non-trending markets, also referred to as range-bound markets, the RSI indicator can also successfully be applied when prices are trending. However, the indicator should not be used in the same manner in the above mentioned scenarios. (see below)
In investment theory, price is a result of the relationship between buyers, also known as bulls, and sellers, commonly referred to as bears.
When the bulls are stronger, and prices go up, it is expected that a retracement will take place at a certain time. When the RSI is in overbought territory, investors consider closing their buy positons. Conversely, when the indicator shows oversold, traders seek to open new buy trades, or close any open sell positions.
General guidelines for using the indicator
The indicator is most commonly used by swing traders. Swing traders recognize that price action is cyclical in nature, and features predictable and frequently occuring retracements. In the absence of trend, swing traders buy assets in oversold areas, and sell them in overbought areas.
If the indicator is set to a standard configuration of 14 periods, overbought at 70, and oversold at 30, traders will act below 30, and above 70. When trading Forex, swing traders open buy positions below 30, and sell positions above 70.
Although the indicator gives an indication of future direction, is is not particulary good for timing entries. Because of this, trades often use the RSI together with candle analysis. In the Forex market, investors known as scalpers, often wait for a strong move downward, to immediately open a buy trade and vice versa. They count on an instant pullback, after which they close their position with profit.
Alternatively, you can wait for price to move out of overbought or oversold, before taking action. This is important, especially if the market is trending strongly.
For both RSI and trend trading algos, be sure to visit our Forex Robot gallery.
RSI parameters
The RSI consists of two parameters. Number of periods and the RSI level itself. The higher or lower the level, the more extreme the overbought and oversold signals become, and the fewer trades you will make.
You can also adjust the sensitivity of the RSI, by simply reducing the number of periods e.g. when periods are set to 7, the indicator looks back only 7 previous candles, not the standard 14. For seeing how the RSI is calculated, click here.
Using the RSI in range-bound markets
In range bound markets, the indicator is in a league of its own. When trading the forex market, essentially you open buy trades when oversold, and sell trades when overbought.
You can choose to wait for confirmation, or be aggressive and trade when as soon as a candle opens in overbought or oversold areas. If you are trading stocks, you go long when the asset is oversold, and go short when overbought.
Here a trader has correctly identified a range bound market, and opens three trades. Two sell trades when the RSI hits 70 or above, and one buy trade when the RSI is at 30 or below. All three trades were profitable. The RSI is well suited for trading range bound markets.
Look for clearly identifiable support and resistance levels, when determining whether the market is range bound or trending.
Making use of the RSI in trending markets
Master traders know that in trending markets, you have to tread carefully with the RSI. When markets trend up, you can observe higher highs, and higher lows. Conversely, when markets trend downward, you will observe lower highs and lower lows.
It is therefore important to note, that in an upward trend, taking a sell trade in overbought territory is risky, as the trend might continue. This applies to oversold as well. (see chart below)
The correct way of applying the indicator in trending markets, is to take buy trades on pullbacks, but only when prices are trending up. (See chart below)
In this example, the trader has used a simple moving average to determine that prices are trending up. She applies an RSI level of 50 to gauge a likely pullback. In this example, for each time a candle closes in the vicinity or below the RSI level of 50, she opens a buy trade. All trades in this sequence were profitable.
Take sell trades when pullbacks happen, but only when prices are trending downwards. (see chart below)
Here we are using our knowledge of the RSI on a currency pair trending down. As in the previous example, the trader has set an RSI level of 50, as pullback indicator, then simply opens sell positions each time the RSI raises up above the level of 50. Always trade in the direction of the trend, also when using the RSI.
Faling to follow these guidelines can lead to disaster.
Conclusions
The relative Strength Index (RSI) is an extremely powerful indicator, and is on a very short list in the company of MACD, Moving Average, Directional Movement System and a few others.
Some investors have gone so far as to say that the only indicator they need, is the RSI. In clearly range bound markets, characterized by support and resistance levels, you can trade the indicator comfortably, and be quite profitable.
In trending markets, you should trade only the pullbacks, and always in the direction of the trend.
