Summary - The Stochastic Momentum Index (SMI) is an enhanced version of a traditional stochastic oscillator. The key difference is that whereas a traditional stochastic oscillator calculates the distance between a securities closing price and its high/low range for a specified period of time, the SMI shows the distance of the closing price in relation to the midpoint or center of its high/low range. In this way, SMI is generally seen to be a more reliable indicator. SMI normally has a range between 100 and -100. Many traders will use the SMI in combination with other technical indicators, including other oscillators.
When interpreting the SMI, a closing price that is higher than the midpoint of the high/low range will have a value higher than zero. A closing price that is lower than the midpoint of the high/low range will have a value less than zero. The SMI has a range of 100 to -100. This wide range is another difference between the SMI and traditional stochastic indicators. The SMI uses a moving average to help smooth the results. Momentum investors commonly use SMI to predict a bullish or bearish trend in order to identify precise entry and exit points. An SMI above 40 is considered evidence of a bullish trend and an SMI below -40 is considered evidence of a bearish trend.
Momentum traders rely on technical indicators to gauge the momentum of price action as it relates to a particular security. Their approach is opposite that of a long-term investor in that a momentum trader is looking to trade with the trend. When a security is moving up, they will buy into it and hope to profit from a short-term rise in price. However, because trends can change quickly, the success of momentum investing is dependent upon reliable technical indicators.
One such indicator is a stochastic oscillator. This is an indicator of momentum that calculates the current closing price of a security and plots it against the moving average for that security over a selected period of time. Traders use the data provided by the oscillator to help capture short-term buy or sell signals that give them entry and exit points for positions. However, one limitation of stochastic oscillators is that they can be choppy, which means that they can be sensitive to price fluctuations particularly over short periods of time. One way investors can offset a choppy oscillator is by expanding the time period (called smoothing the data). But another way is by using the Stochastic Momentum Index (SMI). The SMI is a relatively new tool in trading terms. It’s only been in existence since 1993. But this tool has proven to be a more accurate oscillating indicator.
In this article, we’ll take a close look at the Stochastic Momentum Index and explain how it’s different from traditional stochastic oscillators. We’ll review the advantages and disadvantages of the SMI indicator and review some common trade signals that the SMI provides to investors.
What is the Stochastic Momentum Index?
The Stochastic Momentum Index (SMI) is an indicator of momentum for a security. The SMI is used in technical analysis as a refined alternative to a traditional stochastic oscillator. The SMI is a calculation of the distance of a security’s current closing price as it relates to the median high and low range of prices. This is visually displayed on a stock chart, typically with an exponential moving average (EMA). Technical indicators like the SMI and its predecessor, the stochastic oscillator, are used in momentum investing based on the theory that a security will close at its high when markets are trending upward. Conversely, a security will close at a low when markets are trending downward. Since momentum investors “trade with the trend”, an indicator like SMI is particularly useful. The SMI was developed in 1993 by William Blau in response as an attempt to provide additional clarity to traditional stochastic oscillators.
How the SMI is different from a stochastic oscillator.
A traditional stochastic oscillator will only show a security’s closing price at the end of the time period being measured. So for a daily chart, it will show the closing price for that day. Traders use stochastic oscillators to compare that security’s range of prices over a given period of time. One of the problems that traders have found with traditional stochastic oscillators is their sensitivity to price fluctuations can make them a less reliable predictor of price action. The only way to smooth the level of fluctuation in a stochastic oscillator is to change the time period that’s measured. However, momentum trading relies on holding a position for a short period of time which makes it important to get an accurate view of trends for a specific number of periods. That’s where the SMI comes in. By calculating the distance of a security’s closing price as it relates to its median high and low range, the SMI allows traders to see where the price closed relative to a recent range. This makes the SMI less likely to show a false trend line. And that, in turn, will give traders an indication of whether a trend is at a turning point, or if it will continue in its current direction.
What are the advantages of the Stochastic Momentum Index?
- Predictability – Most technical analysts find the SMI to be less unpredictable than a traditional stochastic oscillator over the same time period.
- Advanced Notice – Momentum traders are looking for early indications of possible momentum shifts at critical points. SMI gives them advanced notice of potential shifts so they can time their moves with clear entry and exit points.
- Less Guesswork – The combination of predictability and advanced notice make the SMI a better indicator for establishing entry and exit points for maximum profit.
What are the disadvantages of the Stochastic Momentum Index?
- Does not predict trendiness – The SMI is showing a moment in time and while very accurate in predicting short-term extreme positions, it is not a good predictor of future direction.
- Requires the use of other indicators – To get a better sense of where a trend is headed, the SMI must be analyzed along with other trendiness indicators such as the R-Squared indicator.
- Does not generate trading signals in trending markets – Other oscillators have to be used with the SMI to see the direction of a trend.
The components of the Stochastic Momentum Index
The two components of the SMI are a %K line and a %D line. Let’s look at each of these separately.
%K Line – this is the main line of the SMI and reflects the price action for the time period being measured. It is usually represented below the stock chart as a solid line.
%D Line – this is the simple moving average of %K. It is usually represented as a dotted line. This moving average is calculated based on the number of the time period specified.
The SMI indicator is bound between a range of 100 and -100. A positive reading indicates that the present closing price is higher than the median of the high/low range. When the number is above 40, it usually indicates a bullish trend. A negative reading indicates the present closing price is lower than the median of the high/low range. When the number is below -40, it usually indicates a bearish trend.
The SMI is considered a fast stochastic oscillator. This means that it is going to be more sensitive to price action and may send out trade signals that do not necessarily confirm a trend. When using a trading program to calculate the SMI, the defaults laid out by William Blau are:
V length – the number of bars used to smooth the SMI = 3
K length – the number of bars used to calculate the SMI = 5
EMA length = 3
If a trader wants to slow down (called smoothing) the SMI, they would increase the number of periods the SMI is reading. This is because the SMI is an indicator of momentum and one of the key triggers for momentum investing is volatility. A volatile security will have more price movement as it is bought and sold.
How to trade using the Stochastic Momentum Index
The Stochastic Momentum Index (SMI) gives off three common trading signals.
- Overbought/Oversold Crossover – As mentioned above the SMI is bound to a range between -100 and 100. When the %K line has a value above +40 that is generally considered an indication that a security is overbought and the trend will move downward. Conversely, when the %K line has a value below -40 it is usually an indication that a security is oversold and the trend will move upward. It’s always important to confirm what the SMI is showing with clear support and resistance levels. Otherwise, you can wind up trading against a trend.
- Signal Line Crossover – A signal line crossover indicates a moment where the %K line crosses over the %D line (or the moving average). When the %K line rises above the moving average it is seen as a buy signal. When the %K line drops below the moving average it is seen as a sell signal. This method can result in traders having a lower “winning percentage”. However, they can increase their odds of making a profitable trade by adding a “neutral zone”. This is typically done between the levels of +/- 15. The idea is that an investor would not trade on any signal line crossovers in this area but use it as a reference point to monitor how the market reacts in terms of support or resistance. If a trend is confirmed, stops can be tightened or traders could add to their trade.
- SMI Divergence – This is the least common indicator, but when it’s observed it can be a very effective trading signal. When a security’s price is closing at higher highs but the SMI is not, that can give an opposing sell signal when price breaks relative support. Conversely, if the security is closing at lower lows, but the SMI is not, that is considered a bullish divergence and it would give an opposing buy signal when price breaks relative resistance.
The bottom line on the Stochastic Momentum Index
The Stochastic Momentum Index, or SMI, is a tool that momentum investors use as part of a trading strategy to help detect securities that are overbought or oversold. It was introduced in 1993 by William Blau in an effort to refine (or clarify) the closing prices are shown with traditional stochastic oscillators. The SMI can be used to smooth out some of the choppiness of a traditional stochastic oscillator by calculating the midpoint of a security's high and low range and showing traders where the closing price is in relation to that midpoint. In this way, the SMI has advantages that include a higher degree of predictability for traders.
The SMI indicator has a range between 100 and -100 with “0” representing the median of the high/low range. When a security closes above zero it means the current closing price is higher than the median, and when a security closes below zero it means the current closing price is lower than the median.
While the methodology behind the SMI is different from traditional stochastic oscillators, they look very similar with a %K line plotted against a %D line (i.e. a moving average). This can give traders some specific signals for setting up entry and exit points for various positions. The most common indicator is to look for a %K line that goes above 40 or below -40. Typically closing prices above 40 on the SMI signal a bullish trend and closing prices below -40 indicate a bearish trend. Another signal is when the %K line crosses over the signal line (or %D line – moving average). Yet another signal occurs when the SMI diverges from the price (the price achieves higher highs or lower lows without a corresponding movement in the SMI).
While the SMI is seen as a highly reliable indicator, traders are not advised to rely solely on this oscillator but to use other technical analysis tools to ensure they are correctly identifying trends.