In order to calculate SMI, start from “N”. Lets suppose N=10. After choosing a Period,
determine the Center of High and Low Range during the period. In order to do so,
use the following formula:
Lets suppose “C” is the center of High and Low, then:
C = (High MAX + Low MIN) / 2
High MAX = The Highest Figure in the Range.
Low MIN = The Lowest Figure in the Range.
After calculating a center point of the range, subtract distance of Current Close
from the Center of the Range.
H = CC TODAY – C
CC TODAY = Current Closing Price.
C = Center of High/Low Range.
In order to smooth the output of “H”, use a 3-period Exponential Moving Average.
Following will be the procedure of smoothing “H”.
HS1 = (H) * (3) * Exponential
HS2 = (HS1) * (3)
* Exponential Moving Average
After smoothing “H”, smooth the difference of High and Low Price during the period
using same 3-Period Exponential Moving Average. Divide the results of Second Smoothing
DHL1 = (High MAX – Low MIN) * (3) * Exponential
DHL2 = (High MAX – Low MIN) * (3) * Exponential
Moving Average / 2
In order to Calculate SMI, divide HS2 by DHL2. Multiplying the output by 100 will
provide results in the form of a percentage.
SMI TODAY = (HS2 / DHL2) * 100
The output of SMI varies between -100 and +100. In order to interpret the outcome
of SMI, traders have developed specific trade points. Like, when SMI rises above
the value of +40, a sell signal is indicated. Similarly, if SMI falls below -40,
a Purchase signal is indicated. Another common trading sign is that, when SMI passes
moving average from below, a purchase signal is generated. Similarly, when SMI falls
below Moving Average, a sell signal is generated. The following chart shows the
bullish entry trade signal generated by the Stochastic Momentum Index.
Trading cannot be based on short term extreme positions only. There must be a mechanism
to check the trendiness of market. R-Squared Indicator is commonly used by traders
to determine the trendiness of market. If the outcome of Indicator like R-Squared
is a non-trending market then outcome of SMI is reliable and gives effective results.
Chande Momentum Oscillator is also frequently used in place of R-Squared Indicator
to determine Trendiness. Contrarily, if a trending market is predicted by Trendiness
Indicators then traders can use Oscillators to determine the direction of trend.
In this way, traders can base their transactions in the direction of market trend
predicted by Oscillator.
William Blau found 1-day SMI with large smoothing periods to be more sensitive to
the current close rather than the high and low of the day. Having high sensitivity
to Closing Value makes SMI an ideal Indicator for Trend Identification. As explained
earlier, there isn’t much difference between the interpretation of Stochastic Momentum
Index and Stochastic Oscillator. Short term extreme positions are indicated by outcome
of SMI. If SMI rises above +40, an overbought condition holds. Traders prefer not
to trade in the direction of trendiness anymore. Similarly, when SMI falls below
-40, an oversold condition holds. Even before trend reversal, traders start taking
their positions to take benefit of the oversold condition. Traders anticipate a
significant trend reversal at Extreme Positions. Divergences must be taken into
account. A divergence can indicate end of a prevailing trend or signal a false trend.
%K cutting %D can also signal crossovers.
Advantages of Stochastic Momentum Index
- Majority of technicians believe that SMI is less unpredictable than Stochastic Oscillator
Outcome for the same period.
- SMI indicates an advance indication of possible
shifts in momentum (Price) close to critical points. This allows traders to time
their moves in the market.
- Entry and Exit with maximum Profits is no longer
an issue due to the predictability of Stochastic Momentum Index.
Disadvantages of Stochastic Momentum Index
- Stochastic Momentum Index is unable to predict trendiness. This makes a lot of confusion
in the mind of traders. Traders often get trapped by seeing the Extreme Positions
indicated by SMI.
- Traders must use Trendiness indicators like CMO (Chande Momentum
Oscillator) or R-Squared Indicator to predict future trends along with SMI which
only predicts short term extreme positions.
- SMI cannot generate trade signals
in trending markets. Oscillators have to be used to generate direction of trend.
Traders can then make decisions on the basis of direction of trend in the future.