Indicator Hack #4: Stochastic Momentum Index

 

Relied on by professional and home traders, the Stochastic is one of the most popular trading tools out there.

But, with this subtle shift in the settings, the Stochastic Momentum Index tweaks it to be smoother, faster and more reliable …

What is the Stochastic Momentum Index?

You may be familiar with the traditional Stochastic oscillator, which is a very powerful momentum indicator. It is built as a measure of the current closing price against the range of the market within a set number of candles.

The issue traders often run into with Stochastics is that it is very jumpy. If you want to smooth it out, you can select a longer timeframe, but this naturally means that it’s going to move more slowly.

The Stochastic Momentum Index neatly deals with this problem with a subtle shift in the calculation, using a median of the midpoint in the trading range.

How to use the SMI indicator

The way we read the Stochastic Momentum Index is just like the Stochastic indicator.

Like most oscillators, there are three main options for how they are applied:

1. As overbought/oversold signals
2. For crossover signals
3. For divergence signals

Which method you apply really depends on the market you’re looking at the move you’re looking to profit from.

I’ll explain …

1. Stochastic Momentum Index Overbought/Oversold Signals

With the Stochastic Momentum Index, the market is considered overbought at levels above +40, and to be oversold at levels below -40.

This kind of use really only works when we have range-bound markets, and even then it can be rather clumsy …

And in a trending market, this method really falls apart …

As we can see above, the indicator is stuck in ‘overbought’ for extended periods as the price continues to trend.

In fact, in a trending market, an SMI level above 40 is considered bullish. While an SMI below 40 would be considered bearish.

So, depending on the whether we’re in a trending market or not, the overbought/oversold signals get flipped on their heads.

Of course, it’s easy to spot trending and range-bound markets in retrospect, but much trickier in real time, which makes using the Stochastic Momentum Index this way problematic.

Here’s another way …

2. Stochastic Momentum Index Crossover Signals

While the SMI is less jumpy than traditional Stochastics, it will give a lot of crossover signals – too many to be useful alone. However these crossovers can be a powerful confirmation tool, when combined with a direction indicator.

A good pairing is the MACD, which gives us a double-crossover signal – we want a crossover on the MACD and a crossover on the SMI at roughly the same time …

3. Stochastic Momentum Index Divergence Signals

The most sophisticated and useful way to read oscillators is with divergence – and the SMI is a particularly powerful tool for this.

In the image above, we get a higher high on the price chart, but the SMI fails to hit a higher high – this suggests that the trend is losing momentum and a correction is due.

On the chart below, we have two kinds of divergence: regular divergence and hidden divergence.

Without going too much into the technical of these types of divergence, what we can see is that the price and the SMI are giving a different story – and this is what gives us our signal.

At A, we have a lower low on the price, but the SMI has produced a higher low – this tells us that the down trend is losing momentum and a correction is due to the upside.

We get a second bullish signal at B. This time we have a higher low on the price chart, while the SMI reading tells us the market is more oversold – again, this signals a correction to the upside.

Putting it into action

The Stochastic Momentum Index is a powerful tool, which is more practical and easy-to-read than standard Stochastics.

Like most indicators, it doesn’t work alone, but needs to be combined with a complementary tool – in this case, a trend indicator is the obvious choice. But you want to add a momentum trigger to your trading – look no further.

 

To enjoy more content and get it faster Follow @TradersBulletin