Using the Stochastic Momentum Index

[RichardCox 10]

Technical analysts rely on price activity because it is perhaps the clearest indication of trader sentiment and market positioning. Of course, there is an incredible variety of ways to approach technical analysis. But, generally speaking, technical traders will attempt to be as objective as possible when reading price action. This approach will allow you to remove your personal biases and go far in removing some of the unnecessary ideas that can cloud your analysis. One way of removing your biases and remaining objective is to use indicators and oscillators to filter the price data.

 

Indicators and oscillators can help traders to view how price is behaving relatively to the larger trend, and to identify areas where extreme movements have become over-extended. This goes far in determining whether or not a specific trade idea has a high probability of success. One of the most common tools in this area is the Stochastic Momentum Index, which allow traders to spot potential turning points in price activity. This type of analysis is critical when looking to determine where prices are trading within the broader context, and where prices are likely to move next.

 

Not Simply Overbought vs. Oversold Price Action

 

As an Oscillator, the Stochastic Momentum Index is usually implemented as a means to finding overbought and oversold market conditions. The main advantage here is that these readings are relatively easy to identify and understand. But there is more to oscillators than simple overbought and oversold readings, and it is usually not recommended to base trade on these readings by themselves. Here, we will look at some of the critical characteristics of the Stochastic Momentum Index so that traders can understand the signals this oscillator sends. This will help those looking to increase the probability of success when these signals are used as part of a bigger trading plan.

 

The Stochastic Momentum Index (SMI) was brought to the attention of markets by William Blau in the early 1990s. Blau’s intention was for the index to help clarify the signals that are sent from the traditional stochastic oscillator, as the SMI makes it easier to see where the closing price of a given period falls in relation to the midpoint of the most recent price low and price high. This helps the indicator send signals to the trader which offer greater perspective in terms of market context. This is important because once we know where closing prices rest (relative to recent ranges or trends), it becomes easier to identify potential turning points (or at least to understand whether or not the current price move has further to travel). Armed with the additional knowledge of historical price ranges, potential changes in trend can be found high a higher level of accuracy.

 

Trading with the SMI

 

When using the SMI for price analysis, it quickly becomes clear that the SMI is faster than the tool used for traditional stochastics, and this can make things more prone to mistakes if the oscillator is not read correctly. As with any charting tool, there will be default settings, but these can be slowed by increasing the number of periods used in calculating the SMI. When looking to start placing trades with the indicator, there are three common approaches. These different methods make the SMI a flexible tool that can be used in a number of different market environments.

 

Overbought / Oversold SMI Readings

 

The most commonly used method for finding trade signals with the SMI comes with the ability to spot instances where the reading crosses into overbought or oversold territory. In many cases, it will be difficult to spot clear levels of support or resistance (to create a workable range). If this is not visible, trading off of simple overbought and oversold readings can be a dangerous prospect. One of the most common phrases in the trading markets is that markets can trend (and remain irrational) longer than you can remain solvent. This can make it difficult to take contrarian positions against the dominant trend (even if prices have sent oscillator readings into overbought or oversold territory).

 

When we look at the SMI to determine these levels, the generally accepted parameters are +/- 40 on the reading. But it is generally a good idea to make sure that a workable range is in place before taking positions based on these readings. The added technical price parameters will result in higher probability trades as long as these signals are in agreement.

 

Crossing the Signal Line in the SMI

 

Another approach is to use the SMI signal line and wait for crossovers in the reading. These signals tend to have a lower probability of success, so it is more important to have additional signals in place before committing to trades. For example, an upward cross of the signal line (indicating prices are starting to turn up from oversold territory) should be accompanied by price levels bouncing off of a clear level of historical support. The combination of these factors will help filter out crossovers that have a lower probability of success (accurate price forecasting).

 

Another way to improve on the probabilities for this strategy is to add a neutral zone to the indicator, using +/- 15 as the key levels. In these areas, signal line crossovers should be disregarded, as price levels are not in “overextended territory.” When this is the case it is less likely that prices are near a major turning point, and this removes some of the added incentive to move into new positions. Examples of SMI crossovers can be seen in the first attached chart, but it should be remembered that crossovers occurring in the middle of the oscillator field will usually be filtered out.

 

SMI Divergences

 

The last major method for using the SMI readings to your advantage can be found with divergences, which show areas where the price action itself is moving in an opposing direction (diverging) from the readings seen on the indicator. Technical divergences can happen on both the buy and sell sides of your price charts but they are not very common. This essentially means that they will send stronger signals when they actually are sent but there will not be as many trading opportunities when looking to implement this strategy. The second chart example shows instance of divergences.

 

For buy positions, a bullish divergence is seen when the oscillator is moving higher as prices are making new lows. Buy positions can be taken here because the oscillator is not confirming the price action, and this generally leads to rallies seen later. An added advantage of trading off of bullish divergences is that traders are able to buy in at extremely low levels before uptrends begin. This means you can get the best price before any bull runs are seen.

 

Conversely, bearish divergences occur when prices are making new highs as the oscillator reading is starting to head lower. The same advantages can be found in bearish divergences, as traders are able to sell into rallies (and get the most expensive price possible) before the major declines are seen later. Confirmation of these signals can be found when major areas of support are broken (for bearish positions), or when major areas of resistance are broken (after bullish divergences are seen).

 

Conclusion

 

The SMI oscillator is a valuable and flexible tool that can be used in many different types of trading. If you are using crossovers, divergences or overbought and oversold readings in your positions, the oscillator can present traders with some great signals that can be used to generate new position ideas. As always, it is a good idea to find a couple of agreeing signals and then to trade in the direction of those signals, as this helps to improve on overall probabilities and creates fewer losing trades.