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The Stochastic Oscillator: A Guide to Understanding and Using this Momentum Indicator Stochastic: An Indicator for Predicting Market Trends
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The Stochastic Momentum Index (SMI): A Refined Indicator for Traders

Introduction to the Stochastic Momentum Index (SMI)

The Stochastic Momentum Index (SMI) is a technical indicator that measures the momentum of an asset’s price. The SMI is a refinement of the stochastic oscillator developed by George Lane in the 1950s. The stochastic oscillator is used to measure the strength of an asset’s price trend, and it is based on the premise that a price trend is more likely to continue than to reverse.

Stochastic Momentum Index

Understanding the Stochastic Oscillator

To understand the SMI, it’s vital first to understand the stochastic oscillator. The stochastic oscillator is calculated by comparing an asset’s closing price to its price range over a certain period. The price range is the difference between the highest and lowest prices over the same period.

The stochastic oscillator generates the %K line and the %D line. The %K line represents the current closing price as a percentage of the price range over a specified period, typically 14 days. The %D line is a moving average of the %K line, usually calculated as a 3-day simple moving average.

Example scanners based on the Stochastic Momentum Index (SMI)

The Stochastic Momentum Index can be used in Scanning the market. To see how exactly it can be used in this way, we provide the following samples. Both scanners search the market for stocks using this indicator.

"TS: Stochastic MI Scan (Long)" scanner by Kevin Shah
charts.trendspider.com
“TS: Stochastic MI Scan (Long)” scanner by Kevin Shah
"TS: Stochastic MI Scan (Short)" scanner by Kevin Shah
charts.trendspider.com
“TS: Stochastic MI Scan (Short)” scanner by Kevin Shah

How the SMI is Calculated

The SMI is calculated similarly to the stochastic oscillator but uses a broader range of values and is more sensitive to closing prices. The SMI is calculated by taking the difference between the current closing price and the median high/low price range over a specified period. This difference is then divided by the absolute value of the high/low range and multiplied by 100.

The SMI generates two lines: the SMI line and the signal line. The SMI line represents the momentum of the asset’s price, while the signal line is a moving average of the SMI line, typically calculated over three days.

Interpreting the SMI

The SMI can be interpreted in a similar way to the stochastic oscillator. When the SMI line crosses above the signal line, it is considered bullish, indicating that the asset’s price momentum is increasing. Conversely, when the SMI line crosses below the signal line, it is regarded as a bearish signal, indicating that the asset’s price momentum is decreasing.

Traders can also use overbought and oversold levels to interpret the SMI. When the SMI line is above +40, it is considered overbought, indicating that the asset’s price may be due for a correction. When the SMI line is below -40, it is considered oversold, meaning the asset’s price may be expected to rebound.

SMI vs. Stochastic Oscillator

While the SMI and stochastic oscillator are similar in many ways, the two indicators have some critical differences. The SMI is considered a refinement of the stochastic oscillator, as it uses a broader range of values and is more sensitive to closing prices. This means the SMI is less subject to false swings and maybe a more reliable indicator than the stochastic oscillator.

Another critical difference between the two indicators is the way they are interpreted. The stochastic oscillator generates two lines, while the SMI generates two lines and uses overbought and oversold levels to analyze the signals. This makes the SMI a more comprehensive indicator that provides more information about an asset’s price momentum.

SMI vs. SMI Ergodic Oscillator

The Stochastic Momentum Index (SMI) and SMI Ergodic Oscillator are popular technical indicators traders use to identify overbought and oversold conditions in the market. While both indicators are derived from the Stochastic Oscillator, the SMI Ergodic Oscillator is considered a refinement of the original SMI. The SMI Ergodic Oscillator is more sensitive to changes in closing prices and uses a broader range of values, making it less prone to false signals than the SMI. Additionally, the SMI Ergodic Oscillator generates two lines and incorporates overbought and oversold levels to provide a more comprehensive analysis of an asset’s price momentum, while the Stochastic Momentum Index generates only one line. Traders often use both indicators together to gain a more complete understanding of market conditions and to make informed trading decisions. 

How to Use the SMI in Trading

The SMI can be a valuable tool for traders who want to identify trends and decide when to enter or exit a position. One common strategy for using the SMI is to look for bullish or bearish divergences between the SMI line and the asset price. A bullish divergence occurs when the SMI line makes higher lows while the asset price makes lower lows. This can signal that the asset’s price will reverse and trend upward. Conversely, a bearish divergence occurs when the SMI line makes lower highs while the price of the asset is making higher highs. This can signal that the asset’s price is about to reverse and start a downward trend.

Traders can also use the overbought and oversold levels to identify potential entry and exit points. When the SMI line crosses above the +40 level, it may be a signal to sell or take profits. Conversely, when the SMI line crosses below the -40 level, it may be a signal to buy or enter a long position.

Limitations and Risks of Using the SMI

While the SMI can be a helpful tool for traders, it is important to consider its limitations and risks. Like all technical indicators, the SMI is based on historic data and does not  guarantee future performance. Traders should always use multiple indicators and analysis methods to confirm their decisions.

The SMI is not foolproof and can generate false signals, especially in choppy or sideways markets. Traders should always be aware of market conditions and use discretion when interpreting signals from the SMI.

Example strategy based on based on the Stochastic Momentum Index (SMI)

The Stochastic Momentum Index can be used in Testing Strategies. To see how exactly it can be used in this way, we provide the following sample. The strategy tests buying and selling rules built around this indicator.

"TS: Stochastic MI Long" strategy by Kevin Shah
charts.trendspider.com
“TS: Stochastic MI Long” strategy by Kevin Shah

The Bottom Line

The Stochastic Momentum Index (SMI) is a refinement of the stochastic oscillator that can provide traders with valuable information about an asset’s price momentum. The SMI uses a broader range of values and has a higher sensitivity to closing prices, making it less subject to false swings and potentially more reliable than the stochastic oscillator. Traders can use the SMI to identify trends, look for divergences, and find potential entry and exit points. However, like all technical indicators, the SMI has its limitations and risks, and traders should always use multiple indicators and analysis methods to confirm their decisions.

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The Stochastic Oscillator: A Guide to Understanding and Using this Momentum Indicator Stochastic: An Indicator for Predicting Market Trends