Purpose

• The DMI/ADX tool is a technical indicator that measures the strength of a price trend. A trend is a momentum in the stock market that tends to continue in a specific direction indefinitely. An up trend leads to higher prices over the duration of the trend, while a down trend causes share prices to drop consistently until the trend ends. In strongly trending markets, it is possible to profit by simply trading stocks in the direction of the trend. Thus, the DMI/ADX helps investors recognize when a strong trend is under way so they may confidently buy shares.
  
  

Warning

• No technical indicator can accurately predict price movement 100 percent of the time. Experienced investors learn to incorporate indicators like the DMI/ADX into their strategies, but you should never wholly rely on any one tool to make your buy and sell decisions. Indicators often give false signals, when they clearly suggest an imminent price movement that does not materialize. You should take care not to place too much investment capital into a new strategy until you have consistent results.
  
  

DMI

• The Directional Movement Index, or "DMI," is a tool comprising two lines that appear beneath the price chart. One line is the positive indicator, and the other is the negative indicator. While the formulas used to compute these lines are complicated, the application of the tool is relatively straightforward. Most investors view these two DMI lines and buy shares of stock when the positive line crosses above the negative line. Then, when the crossover occurs in the opposite direction, this suggests the trend may reverse, which leads some traders to sell their shares.
  
  

ADX

• While the use of the DMI or another technical indicator can be helpful, sometimes it is necessary to first identify the strength of the current trend before trusting these tools. The ADX takes the mathematical calculations of the two DMI lines further to provide a single line that quantifies trend momentum. The ADX rises in response to a strong trend, whether that trend is up or down. Traders typically associate specific levels of the ADX line as the threshold for trend recognition. If the ADX is more than 40, the trend is strong, while a low reading of less than 20 suggests no trend.
  
  

Strategies

• When the ADX is high, above 40, you can then look for a signal from the two DMI lines to enter the trend. If the tend is clearly up, with rising prices, then buy upon the crossover of the positive DMI over the negative line. However, you can also use the ADX solely as a buy signal. As it rises up from less than 20, some traders interpret this as a strengthening trend, even though the ADX is still relatively low, and purchase shares. Or, if a DMI crossover occurs while the ADX line is positively sloped and moving toward 40, they may buy shares, hoping that the ADX will continue to rise and prices take off with a strong trend.