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THE DIRECTIONAL SYSTEM
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The Directional system is a trend-following method. It was developed by J. Welles Wilder, Jr., in the mid-1970s and modified by several analysts. The Directional system identifies trends and shows when a trend is moving fast enough to make it worth following. It helps traders take chunks of profit out of the middle of important trends.

How to Construct the Directional System

Directional Movement is defined as the portion of today's range that is outside of the previous day's range. The Directional system checks whether

today's range extends above or below the previous day's range and averages that data over a period of time. These complex calculations (see worksheet, Figure 27-1) are best performed on a computer. The Directional system is included in most software programs for technical analysis.

•  Identify "Directional Movement" (DM) by comparing today's high-
to-low range with yesterday's high-to-low range. Directional
Movement is the largest part of today's range outside of yesterday's
range. There are four types of DM (Figure 27-2). DM is always a posi­
tive number (+DM and -DM refer simply to movement above or
below yesterday's range).

•  Identify the " True Range " (TR) of the market you analyze. It is
always a positive number, the largest of three:

A. The distance from today's high to today's low

B. The distance from today's high to yesterday's close

C. The distance from today's low to yesterday's close

3. Calculate daily Directional Indicators (+DI and -DI). They allow
you to compare different markets by expressing their directional
movement as a percentage of each market's true range. Each DI is a
positive number: +DI equals zero on a day that has no directional
movement up; -DI equals zero on a day that has no directional move­
ment down.

4. Calculate smoothed Directional Lines (+DI13 and -DI13). Smooth +DI and -DI are created with moving averages. Most software packages allow you to pick any period for smoothing, such as a 13-day moving average. You get two indicator lines: smoothed Positive and Negative Directional lines, +DI13 and -DI13. Both numbers are positive. They are usually plotted in different colors, or as a solid and a dashed line.

The relationship between Positive and Negative lines identifies trends. When +DI13 is on top, it shows that the trend is up, and when -DIjj is on top, it shows that the trend is down. The crossovers of +DI13 and give buy and sell signals.

5. Calculate the Average Directional Indicator (ADX). This unique component of Directional system shows when a trend is worth follow­ing. ADX measures the spread between Directional Lines +DI^3 and -DI^3. It is calculated in two steps:

Figure 27-2. Directional Movement

Directional Movement is the largest part of today's range that is outside of yesterday's range.

A. If today's range extends above yesterday's range, Directional
Movement is positive (+DM).

B. If today's range extends below yesterday's range, Directional
Movement is negative (-DM).

C. If today's range is inside of yesterday's range or extends above and
below it by equal amounts, there is no Directional Movement (DM =
0). If today's range extends both above and below yesterday's range,
DM is positive or negative, depending on which part of the "outside
range" is larger.

D. On a limit up day, +DM equals the distance from today's close to yes­
terday's high. On a limit down day, -DM equals the distance from
today's close to yesterday's low.

When a trend proceeds in a healthy manner, the spread between two smoothed Directional lines increases and ADX rises. ADX declines when a trend reverses or when a market enters a trading range. It pays to use a trend-following method when ADX rises and not when ADX declines.

Crowd Behavior

The Directional system tracks changes in mass bullishness and bearishness by measuring the capacity of bulls and bears to move prices outside of the previous day's range. If today's high is above yesterday's high, it shows that the market crowd is becoming more bullish. If today's low is below yester­day's low, it shows that the market crowd is becoming more bearish.

The relative position of Directional lines identifies trends. When the Positive Directional line is above the Negative Directional line, it shows that bullish traders dominate the market. When the Negative Directional line rises above the Positive Directional line, it shows that bearish traders are stronger. It pays to trade in the direction of the upper Directional line.

The Average Directional Indicator ADX rises when the spread between Directional lines increases. This shows that market leaders are becoming stronger, losers are getting weaker, and the trend is likely to continue. When the ADX rises, it pays to trade in the direction of the upper Directional line, using a trend-following method.

ADX declines when the spread between +DI13 and -DI13 narrows down. This shows that the dominant market group is losing its strength, while the underdogs are gaining. Then the market is in turmoil, and it is better not to use trend-following methods.

Trading Rules

1. Trade only from the long side when +DI13 is above -DI13. Trade only from the short side when -DI13 is above +DI13. The best time to be long is when both +DI13 and ADX are above -DI13 and ADX rises. This shows that the uptrend is getting stronger. Go long and place a

protective stop below the latest minor low. The best time to be short is when -DIj3 and ADX are above +DI13 and ADX rises. This shows that bears are becoming stronger. Go short and place a protective stop above the latest minor high.

2. When ADX declines, it shows that the market is becoming less direc-

tional. There are usually many whipsaws, just as there are turbulences in the water during the change of tide. When ADX points down, it is better not to use a trend-following method.

•  When ADX falls below both Directional lines, it identifies a flat,
sleepy market. Do not use a trend-following system but start getting
ready, because major trends emerge from such lulls.

•  The single best signal of the Directional system comes after ADX falls
below both Directional lines. The longer it stays there, the stronger the
base for the next move. When ADX rallies from below both Directional
lines, it shows that the market is waking up from a lull. When ADX
rises by four steps (i.e., from 9 to 13) from its lowest point below both
Directional lines, it "rings a bell" on a new trend. It shows that a new
bull market or bear market is being born (Figure 27-3). Buy if +DI13 is
on top and place a stop below the latest minor low. Sell short if -DI13 is
on top and place a stop above the latest minor high.

For example, if ADX rises from 8 to 12 while both lines are above 12 and +DI13 is on top, it indicates that a new uptrend is beginning. If ADX rises from 9 to 13 while both lines are above 13 and -DI13 is on top, it shows that a new downtrend is starting.

The Directional System is unique in telling you when a major new trend is likely to begin. It rings a bell once or twice a year in any given market. It signals when a new baby bull or baby bear is being born. Monetary risk is usually low at that time, due to low volatility while the trend is still young.

5. When ADX rallies above both Directional lines, it identifies an over­
heated market. When ADX turns down from above both Directional
lines, it shows that the major trend has stumbled. It is a good time to
take profits. If you trade multiple contracts, you definitely want to take
partial profits.

Market indicators give hard signals and soft signals. For example, a viola­tion of a price low or a change in direction of a moving average are hard signals. A downturn of ADX is a soft signal. Once you see ADX turn down, you ought to be very, very careful about adding to positions. You should start taking profits, reducing positions, and looking to get out of your position rather than adding to it.

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