Nurwilda-Directional Movement Index [PDF]

Citation preview

STOCK EXCHANGE IN MATHEMATICS “Directional Movement Index”



Submitted to fulfill the report task, by the lectrurer: Ahmad Zaki S.Si, M.Si



By: Nurwilda 1711440009



DEPARTEMENT OF MATHEMATICS FACULTY OF MATHEMATICS AND SCIENCE UNIVERSITAS NEGERI MAKASSAR 2020



Background Patrick and Wai (1973) argued that stock markets are those markets that deal with capital, both in the short and long-term, where companies sell stocks in order to generate long-term capital that can be channelled into their profitable options. This is because people would rather invest in winners than losers; buyers hold on to their stocks for future dividend payouts. The activities of buying and selling stocks and shares on the stock market are extremely significant for the allocation of capital within economies (Najeb M.H Masoud, 2013). Basically, the thing that most influences changes in stock prices is the strength of demand and supply. To find out these changes, whether prices will rise or prices will fall then we need an analysis that can predict it. There are two analysis that can be used by investors, namely Technical Analysis and Fundamental Analysis. Fundamental analysis means financial statement analysis of an organization or extract the intrinsic value of the share of a company and differentiate whether this price is below or above the market price of that particular share or not. While Technical Analysis is an analysis that estimates future price movements by looking at past price movements. Modern technical analysis is also grouped into several groups according to their characteristics, namely trend following indicators, oscillator indicators, and miscellaneous indicators. trend following indicator is an indicator that follows the trend of stock price movements, as for example the moving average divergence convergence, moving average, directional movement system, accumulation / distribution, and on balance volume. While oscillator indicators are indicators that identify turning points that can occur in a stock, for example the stochastic oscillator, williams% R, and the rate of change. For miscellaneous indicators are indicators that give special indications about the psychology of the mass (market participants), for example the advance / decline index, the bullish consensus, and the new low index. Where in this paper, the author only discusses about the directional movement index which is one of the analytical tools in the directional movement system.



Definition of Directional Movement Index The concept of Directional Movement is based on the assumption that in an upward trend today’s highest price is higher than yesterday’s highest price, and in a downward trend today’s lowest price is lower than yesterday’s lowest price. If this is the case, it is a matter of the so-called Outside Days. The difference between today’s high and yesterday’s high



corresponds to the Plus Directional Movement (+DI). The difference between today’s low and yesterday’s low is the Minus Directional Movement (-DI). These Outside Days consist of a +DI as well as an -DI. The Directional Movement Index, or DMI, is an indicator developed by J. Welles Wilder in 1978 that identifies in which direction the price of an asset is moving. DMI is a technical indicator that usually depicts below or above the price chart. This is calculated by comparing the current price with the previous price range, and displaying the results as an upward movement path (+ DI), and a downward movement line (-DI), with a range between 0 and 100. DMI also calculates upward movement or down, and display the results as a strength trend (ADX). In other words, this Indicator measures the Strength or Weakness of a Trend. This does not indicate whether the trend will rise or the trend will go down, it only shows you who want to add to the trend. The Direction Movement Index consists of: a. The Positive Direction Indicator (+DI) summarizes upward trend movement b. The Negative Direction Indicator (-DI) summarizes downward trend movement c. The Average Directional Movement Index (ADX) indicates whether the market is trending or ranging. Directional movement index is one indicator of technical analysis that serves to detect the formation of a trend. Directional movement index is used to see the direction of the actual stock price movement by comparing the trading range of one day with the trading range of the previous day. Based on the direction of movement, the formation of trends can be divided into 3, namely: 1. Uptrend, which is stock prices tend to move up 2. Downtrend, which is a stock tends to move down. 3. Sideways Trend, i.e. stagnant price movements, prices only go up or down at a certain price range.



Definition of Average Directional Index The ADX is an indicator that measures trend strength rather than direction. The higher the ADX value, the stronger the trend, regardless of whether the market is going up or down. The indicator was developed on daily data, but it can be applied to any time frame. Although



the ADX concept is straightforward, its calculation is rather lengthy. The indicator was designed by Welles Wilder and is described in detail in his book New Concepts in Technical Trading Systems (Trend Research, 1978). Although it’s included in most analysis, it’s important to understand how any indicator works (Ken Calhoun, 2010). ADX is usually attached to the chart along with two lines called the Directional Movement Indicators (DMI). ADX itself is the average of these two lines. First is the + DI line, which reflects how strong or weak the uptrend is in the market. The second is the DI line, which describes how strong or weak the downtrend is. The ADX line is a combination of + DI and -DI, but does not indicate whether the market is uptrend or downtrend, only the strength of the overall trend. The most important feature of ADX is it informs us whether we are in a trend or not and also the degree of strength of the trend. If we are in a trending phase we have to use trend following indicator like MACD, Moving Averages or if we are in a Range-Bound (Consolidation) phase we have to use oscillator like Relative strength Index (RSI) (Sarbajit Paul, 2016) ADX is usually based on the movement of two ADX indicators, namely (+ DI) and (-DI). (+ DI) indicates an upward pressure on prices (up), while (-DI) indicates downward pressure on prices (down). ADX has a range of values ranging from 0 to100. ADX which is under 20 shows a weak trend, whereas if it moves above the value of 40, indicates a strong trend. In the ADX indicator, we can identify 2 conditions, namely: trend and non-trend (trading). Trading means the stock price moves sideways. When ADX moves fast from below the value of 20 to values above 20, then this condition indicates the building of a trend, as well as a signal of the end of trading. And when the ADX indicator moves from above the value of 40 to the value below 40, then this condition indicates the establishment of trading, and the end of a trend.  When the trend is strong enough (the ADX line indicates a trend), a buy signal is shown when the line (+ DI) crosses from below the line upward (-DI), which means that the pressure of an increase in price is greater than the pressure of its decline, and vice versa a sell signal is shown when line (-DI) intersects from the top down the line (+ DI). The extreme point, which is the intersection between (+ DI) and (-DI), can function as a market entry or exit point. But investors are expected to be cautious when stock prices move sideways (usually when price volatility is high), because ADX can give fake (reverse) buy or sell signals in the short term.



Mathematical Formula of Directional Movement Index



Directional Movement Index (DMI) consists of two types, namely + DI and -DI. Usually DI (+/-) done in a number of periods. + DIn=



+ DMn × 100 % TRn



−DIn=



−DMn × 100 % TRn



With : + DM = moving average of + DM over several periods - DM = Moving average of -DM for several periods TR



= Moving average of TR for several periods



DI



= DI for n periods



Directional Index (DX) is a measure used to calculate the relative magnitude of price movements. Where:



|



DXn=



( + DI ) n−(−DI ) n × 100 % (+ DI ) n+ (−DI ) n



|



With: + DIn = simple moving average + DI in n periods -DIn = Simple moving average -DI in n periods The period that is often used to calculate DX is 14 days. Because DX still often gives false signals, then the next Wilder develop an Average Directional Index analysis. According to Hendra Syamsir (2004), "ADX is nothing but a line obtained from the DX moving average." The ADX line is usually used to measure the strength of stock price trend movements. By using this ADX, users can see whether the price of a stock is in the middle of a trend or only make a small movement in a trend sideways. The period recommended by Wilder to calculate ADX is 14 using the Simple Moving Average Method



ADX=



( DX ×13 )+ ADX −1 14



Graph Analysis of Directional Movement Index ADX is usually attached to the chart along with two lines called the Directional Movement Indicators (DMI). ADX itself is the average of these two lines. First is the + DI line, which reflects how strong or weak the uptrend is in the market. The second is the DI



line, which describes how strong or weak the downtrend is. The ADX line is a combination of + DI and -DI, but does not indicate whether the market is uptrend or downtrend, only the strength of the overall trend. As mentioned, ADX measures the strength of a trend. In measurement, the three lines above move in the range of 0 and 100. However, the designers set 60 and 20 as extreme limits. If the ADX line moves above 40 and continues to climb, indicating that the current trend is quite strong, regardless of uptrend or downtrend. If the line moves below 20, it indicates a weak trend and the market in ranging conditions. Prices can move trending or trading. 1. Trending, prices move according to certain trends. Can be an uptrend, where prices have a tendency to rise. Or downtrend where prices tend to continue to fall. Following is the explanation of uptrend and downtrend: a) Uptrend An uptrend pattern formed from a group of price value data charts that always form a new high value / higher high, and the lowest price value is higher / higher low than the previous lowest price value. Data graphs of these price values can usually be represented by bar charts, line charts, or candlesticks. b) Downtrend Is a pattern of downtrend / downtrend formed from a group of price value data charts that always form the value of the highest price / lower high, which is lower than the previous highest price value, and the value of the lowest price that is lower / lower low than the value of the previous lowest price. Data graphs of these price values can usually be represented by bar charts, line charts, or candlesticks. 2. Trading, prices move back and forth in a narrow range (sideways). Sideways is a sideways tendency pattern formed from a group of data graphs of price values that always form the same highest price value than the previous highest price value and the lowest price value which is also equally flat than the previous lowest price values. Data graphs of these price values can usually be represented by bar charts, line charts, or candlesticks.



Trend Line Graph



Example of indicator ADX



Because ADX measures the strength of a trend, traders use this indicator to confirm whether the market is in a trend, and avoid periods ranging in the market, conditions that are difficult to get profit. In addition, in situations when the ADX line moves below 20, the designer suggests not trading trend based strategies when the ADX line is below both the DI and -DI lines.



Example of line ADX below + DI and -DI



Another approach used by traders is to identify the potential for the beginning of a new trend in the market. The trick is to monitor the movement of the ADX line from below 20 upwards as a signal the market is heading for a new trend. The longer the market ranges, the greater the weight traders give to this signal. Example of a signal of a change in trend in ADX



This indicator can also be used as a trend reversal signal. When the ADX line moves above + DI and -DI then moves down, then this is often used as a signal of a change in trend.



Example of a signal of a change in trend in ADX



The last approach that traders use in ADX is crossover. When the line + DI breaks above the -DI line, indicating that buyers are stronger than sellers, so this is a buying opportunity. When the + DI line breaks below the DI line, indicating the seller is stronger than the buyer, this becomes a selling opportunity. Note: a. The ADX line is in the 0-20 region = don't take a position, because the price is still in consolidation stage. b. ADX line is in the area of 20-30 = Get ready to take a position, because in this area the price is starting to move either uptrend or downtrend. c. ADX lines are in the 30-40 area = Trends that occur are strong, both uptrend and downtrend. d. The ADX line is in the area 40-100 = The trend is being strong, it will soon be over (position X in the picture above).



Conclusion The Directional Movement Index, or DMI, is an indicator developed by J. Welles Wilder in 1978 that identifies in which direction the price of an asset is moving. DMI is a technical indicator that usually depicts below or above the price chart. In other words, this Indicator measures the Strength or Weakness of a Trend. This does not indicate whether the trend will



rise or the trend will go down, it only shows you who want to add to the trend. Where DMI consists of; Positive Direction Indicator (+DI) summarizes upward trend movement, Negative Direction Indicator (-DI) summarizes downward trend movement and Average Directional Movement Index (ADX) indicates whether the market is trending or ranging. One of the advantage of DMI is good for detect long-term trends, such as: to see the direction of the actual price movement by comparing the trading range of one day with the trading range of the previous day. To see the stock and measure the strength of prices in an uptrend or downtrend, but has a low response to short-term price changes. ADX is usually attached to the chart along with two lines called the Directional Movement Indicators (DMI). ADX itself is the average of these two lines. First is the + DI line, which reflects how strong or weak the uptrend is in the market. The second is the DI line, which describes how strong or weak the downtrend is. The ADX line is a combination of + DI and -DI, but does not indicate whether the market is uptrend or downtrend, only the strength of the overall trend.



References Paul, S. (2016). An Empirical Study on Nifty Stocks by applying ADX and Moving Average. S.S.M. Journal of Science and Humanities, 16. Masoud, N. M. (2013). The Impact of Stock Market Performance upon Economic Growth. International Journal of Economics and Financial Issues, 11. Calhoun, K. (2010). ADX breakout scanning. Tranding Strategies, 6.