Trading strategy: DMI Divergence

Description

Trading strategies based on diverengence logically assume that when the price curve and the indicators diverge, it will be the price curve which will change direction. The February 2011 edition of the German Traders’ Magazine contained an article on a divergence strategy called Topsy Turvy. The strategy turns the basic divergence premise on its head by assuming that the price curve is correct and that the indicators will change direction.

When building and back-testing the Topsy Turvy strategy, however, it was found that the basic divergence premise –in case of divergence between price curve and indicators, the price curve will change direction– still yielded the best trading results. This observation resulted in the DMI Divergence strategy. The strategy uses the special divergence indicator from Topsy Turvy but … still works on the basic divergence premise: in the case of divergence the price curve will change direction.


   
Suitable for : Market indices (FTSE, DAX, CAC, AEX ...)
: Forex (EUR/USD ...)
: Commodities (oil, gold …)
Instruments : Futures, CFD and Forex
Trading type : Day trading
Trading tempo : 3-5 Signals per week
The strategy : Video
Using NanoTrader Full : Manual or semi-automated

 

The strategy in detail

Topsy Turvy monitors the price curve against a directional movement (DM) concept to detect divergence. In the domain of technical analysis there is the up DMI and the down DMI.


It is possible to calculate a DMI Spread out of the difference between the up DMI and down DMI.

 

This screenshot shows the price curve and below the DMI Spread curve.


 

This screenshot shows a bullish divergence. The price curve is down over he look-back period whereas the DMI Spread indicates that the underlying market current is bullish. This represents a buy signal.


 

This screenshot shows a bearish divergence. The price curve goes up over he look-back period whereas the DMI Spread indicates that the underlying market current is bearish. This represents a short sell signal.


In order to visualize divergences more clearly it is possible to use a value chart showing the bullish divergence (price curve down, indicators up) as arbitrary value "75" and the bearish divergence (price curve up, indicators down) as arbitrary value "25". So the signal is provided by the DMI Spread and its relation to the price curve.

 

In this screenshot two signals occur. A buy signal on 11 January and a short sell signal on 13 January.

When to open a position?

A position is opened on a 15-minute chart whenever a divergence occurs between the 56-period DMI Spread and the price curve. The directions of the DMI Spread and the price curve are detected on the basis of 21 and 55 look-back periods. One look-back period should be about a day and the other half a day.

Attention. Back-testing has shown that shorter look-back periods are required when the DMI Divergence strategy is applied to financial instruments such as currencies (forex) which are subject to more pronounced short-term trend changes.

A long position is opened when bullish divergence (indicators are bullish but the price curve goes down) occurs. A short position is opened when bearish divergence (indicators are bearish but the price curve goes up) occurs.

When to close a position?

An open position is either closed when the opposite divergence occurs or when the stop is touched. The DMI Divergence strategy uses a 50-point trailing stop.

 

This screenshot shows the same two signals as above. The first position is closed when the opposite divergence occurs (a bearish divergence after a bullish divergence). The second position is closed when the trailing stop is touched.


 

This screenshot shows the results of a back-test of the DMI Divergence strategy on the Euro Stoxx 50 market index. It should be possible to improve the result by adding trend filters and/or volatility filters.


Conclusion

The DMI Divergence strategy uses the DMI Spread indicator (see Topsy Turvy trading strategy in Traders’ Magazine 2/2011) to detect divergence. However, contrary to Topsy Turvy, the DMI Divergence strategy sticks to the basic divergence premise: when divergence occurs between the price curve and the indicators, the price curve is most likely to change direction. This strategy can be used on a large variety of instruments such as market indices, gold, oil, forex… . The number of signals is about 3-5 per week. The results in a back-test look fairly robust.

Practical implementation

In NanoTrader Full follow these steps:
  • Choose the instrument you wish to trade.

  • Open a chart with the template study "WHS 21h52".

  • The template is set up to trade the Dow index (minimum movement 10 points, stop 20 points). If you want to trade the S&P 500 set the minimum movement to 1 point (4 ticks) and the stop to 2 points (8 ticks).

  • Semi-automated trading? Simply activate the TradeGuard+AutoOrder or the AutoOrder function.