The stochastic momentum index (SMI) is like the stochastic oscillator on steroids and was brought to the trading world by William Blau.
Instead of reading the closing price of the asset as the standard stochastic indicator, the SMI will calculate the closing price in relation to the average of the high/low range.
Momentum traders are looking to take advantage of any increase in momentum, generally in the direction of the trend. The SMI, since it uses a range of data, is considered to be a better and faster read on the changes in momentum.
Stochastic Momentum Index Breakdown
Oscillators like the SMI are often called oversold and overbought indicators.
There are two lines called %D and %K that we need to pay attention to:
- %K is usually set to 5 and represents the main movements of price – slow line
- %D is the fast line, a simple moving average of the %K and is set to 3
These two lines oscillate between the values of +100 and -100. The 0 line is the median of the high/low range of our look back period.
Another level, +/- 40, is where traders will determine a market to be overbought or oversold.
- +40 is considered overbought
- -40 is considered oversold
The oversold level is the green line and the overbought level is the red line. If this was your style of trading, you’d take special note when the stochastic momentum index is around these zones.
When the current closing price plot is higher than the average of the high/low, we see a positive return on the SMI
If the current closing plot is lower than the average of the high/low, we will see a negative return plotted.
Trading With The Stochastic Momentum Index
There are 3 main trading strategies when using the SMI:
- Oversold and overbought
- Crosses of the lines
- SMI divergence
As with any trading indicator, I would add some other type of confirmation such as price patterns or price action before placing a trade
While others will see +40 or -40 as showing strength or weakness in terms of trend, others will see those SMI levels as potential zones of price reversal.
On this chart, we can see that the stochastic momentum index had a run of good trading signals nailing the turning points but we were also in a trading range. Once price began to trend, the SMI oversold signals gave little upside as price was trending downwards.
The lesson here is while trading oversold and overbought in a trading range may work, blindly following those trading signals in a trend market can be painful. Ensure you can see defined support and resistance levels before thinking about using the SMI in this manner.
What we do notice is those same levels can act as a trend determination tool where +40 is bullish and -40 is bearish.
In this case, we are looking for momentum divergence where in an uptrend price is putting in a higher high but the SMI does not. The opposite is also true.
This is a chart of Bitcoin with 2 momentum divergences (bearish divergence) that we would be interested in.
It is never smart to simply trade these as sell signals but on this chart, we have failure tests of the highs.
This is where price pokes above resistance and immediately (with 2-3 candles), falls back below.
If you choose to trade divergence, your stop loss would go just above the swing high for short trades and the swing low for long trades. The reason is that if this trade fails, the overall trend direction may be regaining ownership of the chart.
Signal Line Crossover
This is the easiest uses of the SMI where we watch the relationship between the %K and %D for buy and sell signals.
- %K crossing over to the upside of the %D, that is a buy signal
- %D crossing to the downside under %K, consider that a sell signal
Is it wise trading to trade the crosses without confirmation? Let’s take a look.
The blue lines on the indicator are a buffer zone. If crosses happen within the buffer zone, they are ignored. This is to help prevent getting chopped up in markets that have no direction. The logic is that once the signal lines start to climb, we are seeing a momentum increase and choppy market conditions are less likely.
We took buys when the cross was below the zero and sells above zero.
Interesting to note is where the blue line is, you’d hold that sell position because the cross back up, happens in the buffer zone.
Stochastic Momentum Oscillator – The Bottom Line
I purposely left out profit taking and trade management plans deciding to stick with the usage of the SMI.
While the SMI will point out divergences and momentum shifts, it is my feeling that you must add in other confirming factors, including price structure.
The best usage in my opinion would be to use it in a range and as a trade entry technique.
As an example, if price is sitting on support and begins to bounce, use a cross to the upside of the SMI as your trade entry.