Chande Momentum Oscillator Trading Strategy – Setup, Rules And Backtest

There are countless technical indicators that traders look at. Among the most popular that try to gauge momentum are the RSI and the stochastic indicator. However, today, we will learn about one that is not so well-known: Chande momentum oscillator (trading strategy).

The Chande momentum oscillator is a technical indicator that measures momentum through the daily value change in the security. But the question arises: Can a profitable strategy be developed using it?

In this article, we are going to look at what the Chande momentum oscillator is, how to calculate it, and backtest a trading strategy using Python to see whether it is profitable or not.

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What is the Chande Momentum Oscillator?

The Chande momentum oscillator is a technical indicator similar to the RSI and stochastic indicator, introduced by Tushar Chande in his 1994 book The New Technical Trader. It measures momentum in both the up days and down days.

The indicator oscillates between +100 and -100, and triggers oversold signals when under -50 and overbought signals when over +50. It is also possible to add a moving average to the indicator to act as a signal line.

How to Calculate The Chande Momentum Oscillator

The Chande momentum oscillator is pretty easy to calculate. Here is a step-by-step guide to how to do it:

Chande Momentum Oscillator = ((UP – DOWN) / (UP + DOWN)) * 100

1. Determine the change between the closing price of the current period(i) and the preceding one(i-1). 
2. When the change is a positive value, add it to the cumulative total of up days (UP) within the designated time frame. 
3. Conversely, if the change is negative, include its absolute value(positive) in the cumulative total of down days (DOWN) over the specified interval. 
4. To compute the Chande Momentum over the prescribed period, calculate the difference between UP and DOWN and divide it by the combined overall movement (UP + DOWN).
5. The result is expressed as a percentage, so multiply it by 100.

Chande Momentum Oscillator – trading rules

We are going to backtest a trading strategy using the Chande momentum oscillator for a 9-day period (this is the most used timeframe).

The trading rules are the following:

Trading Rules

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Chande Momentum Oscillator – backtest

We backtested the trading strategy using the SPY ETF. The data is adjusted for dividends. Here is the equity curve for our Python backtest:

The returns don’t look appealing at first, but here are some good metrics and performance statistics about the strategy:

• CAGR is 4.19% (buy and hold 9.90%)
• Time spent in the market is 15.63%
• Risk-adjusted return is 26.80% (CAGR divided by time spent in the market)
• Maximum drawdown is -34.63% (-55.19%)

As you can see, the oscillator works better than we imagined by just looking at the equity curve. Because it is invested so little time, the risk-adjusted return is very high, and the drawdown is much lower than buy and hold. 

It is also important to note that we put a 5-day maximum holding period because we noted that it worked pretty well. However as we increased the holding period to 10, 15, and 30 days, the returns of the strategy decreased.

Chande Momentum Oscillator – conclusion

To sum up, the Chande momentum oscillator can be used to develop a profitable trading strategy. Although there are many ways to do it, today we show you one where, on a risk-adjusted basis, beats buy and hold by a sizable amount. If combined with other indicators and incorporated into a trading system, the potential for the indicator may be more significant than anticipated.

What is the Chande Momentum Oscillator (CMO)?

The Chande Momentum Oscillator (CMO) is a momentum-based trading oscillator that is used to assess the relative strength or weakness in a financial market. It measures the difference between the sum of recent higher closes and that of recent lower closes and then divides the result by the sum of all price movements over the chosen period, which is usually 20 periods. It then multiplies the result by 100 to turn it into an oscillator that oscillates between -100 and +100 range.

Positive values (values above zero) indicate strength, while negative values suggest weakness. However, proper interpretation takes into consideration the direction of the trend. The indicator is also used to identify potential overbought (above +50) or oversold (below -50) conditions, as well as potential price reversals using its divergence with the price swings.

How does the Chande Momentum Oscillator work in trading?

In trading, the Chande Momentum Oscillator works as a momentum oscillator and uses various signals to measure the trend strength, indicate overbought/oversold conditions, and show potential price reversals.

The indicator ranges from -100 to +100. In an uptrend, values above zero indicate strength, and values below zero indicate weakness — the higher, the value, the stronger the trend. The opposite is the case for a down-trending market. Overbought conditions occur when the indicator reaches the +50 level and oversold conditions occur when it reaches −50.

The swings of the CMO can also form patterns, such as double bottoms and tops, and they may also form trends. But the most important pattern is when its swings are out of phase with the price swings, giving rise to divergence signals, which may suggest potential price reversals. A bullish divergence occurs when the price is making a lower low and the indicator is making a higher low. Likewise, a bearish divergence occurs when the price is making a higher high and the indicator is making a lower high.

Some traders also add a 9-period moving average of the CMO to the indicator as a signal line. When the indicator crosses above the signal line, they consider it a bullish signal, and when it drops below the signal line, they consider it a bearish signal.

Who created the Chande Momentum Oscillator?

The Chande Momentum Oscillator was created by Tushar Chande, who first introduced the indicator in his 1994 book, “The New Technical Trader”. Tushar Chande is a renowned trading system wizard and is internationally recognized as an innovator in technical analysis. He is the President of LongView Capital Management and a registered Commodity Trading Advisor. Chande holds nine U.S. patents.

What is the formula for calculating the Chande Momentum Oscillator?

The formula for calculating the Chande Momentum Oscillator is given as follows:

Chande Momentum Oscillator = 100 x (SHc — SLc) / (SHc + SLc)

Where:

SHc = the sum of higher closes over n periods

SLc = the sum of lower closes over n periods

To calculate the CMO, here are the steps to take:

1. Determine the higher closes over n periods and sum them up — a higher close is when the index price bar’s close is higher than the preceding bar’s close.
2. Determine the lower closes over n periods and sum them up — a lower close is when the index price bar’s close is lower than the preceding bar’s close
3. Subtract the sum of lower closes from the sum of higher closes
4. Add the sum of lower closes to the sum of higher closes
5. Divide the result from step 3 by the result from step 4 and then multiply by 100
6. Repeat for each new price bar printed and plot the results

How do you interpret the CMO values?

To interpret the CMO values, you have to take into consideration the direction of the trend. The CMO values range from -100 to +100, and being a momentum oscillator, the indicator can have any value in any trend. In an uptrend, CMO values above zero indicate strong momentum for the uptrend — the higher, the value, the stronger the trend. Values below zero indicate weakness, but values below -50 indicate an oversold condition, which may suggest that the next upswing may be about to start. Overbought conditions are not reliable in a strong downtrend.

The opposite is the case for a down-trending market. In a downtrend, CMO values below zero indicate strong momentum for the downtrend, and values above zero indicate weakness in the downside momentum. However, values above +50 indicate an overbought condition, which may suggest that the next downswing may be about to start. Oversold conditions are not reliable in a strong downtrend.

What are the key levels in the Chande Momentum Oscillator?

The key levels in the Chande Momentum Oscillator include:

• The zero (0) level: This is the midpoint of the indicator, which demarcates between positive and negative momentum. Values above the zero level indicate positive (upside) momentum, while values below indicate negative (downside) momentum.
• The +50/-50 level: The +50 and -50 levels are used to indicate overbought and oversold conditions in the market. The reliability of this signal depends on the type of trend.
• The +100/-100 level: The +100 and -100 levels are the extreme points of the indicator.

How does CMO differ from other momentum indicators?

The CMO differs from other momentum indicators in some ways, even though they all try to measure the same thing. While it uses the difference between the sum of higher closes and the sum of lower closes over a chosen period to estimate the trend momentum, other momentum indicators, such as the RSI, use the ratio of the higher closes to the lower closes. Stochastic, on the other hand, compares the recent close to the price range over the chosen period.

What are the advantages of using the Chande Momentum Oscillator?

The advantages of using the Chande Momentum Oscillator include the following:

• The indicator can show the direction and momentum of price swings and trends via zero-level crossovers or signal line crossovers.
• It can show overbought and oversold conditions in the market when the indicator line reaches the +50 in a downtrend and the -50 level in an uptrend respectively.
• It can show potential market reversals through its divergences from the price swings.
• It can be used to improve the signals from indicators trend-following and momentum strategies.

How can you use CMO in a trading strategy?

To use CMO in a trading strategy, you need to understand how the indicator works so you can know how to use it to create a trading strategy or improve an existing one. When creating a new strategy, the CMO works better with trend indicators, such as moving averages, or tools like trendlines, which can show the direction of the trend, as well as serve as dynamic support or resistance level. With such, you can use the CMO to spot the end of pullbacks so you can trade in the trend direction and ride the next impulse wave.

What are common mistakes when using the Chande Momentum Oscillator?

Some of the common mistakes when using the Chande Momentum Oscillator include:

• Using the indicator to identify the main trend while it can only show the momentum of short-term trends.
• Taking overbought/oversold levels and divergences as trading signals
• Using the indicator as a standalone strategy without combining it with trend indicators, such as moving averages to identify the main trend — so as not to trade against the trend.
• Not having a backtested strategy with clear entry and exit criteria and risk management parameters.

Can the CMO be used for trend identification?

No, the CMO cannot be used for trend identification, as it is just a momentum oscillator that shows the strength of price swings and not a trend-following indicator. At most, the CMO can only show short-term trends that constitute the impulse and pullback swings of a main trend — it cannot show the main trend itself, except on a much higher timeframe where that trend becomes a mere swing. It is essential to always combine the indicator with a trend indicator, such as a moving average, or at least a trendline.

How does the CMO help in identifying overbought or oversold conditions?

The CMO helps in identifying overbought or oversold conditions by showing readings above the +50 level or -50 level respectively. However, the reliability of the overbought/oversold conditions is trend-dependent.

In a strong uptrend, overbought conditions are not reliable, as the indicator can keep showing values greater than +50 for a long time. However, values below -50 indicate an oversold condition during a pullback, which may suggest that the next upswing may be about to start.

Similarly, in a strong downtrend, oversold conditions are not reliable, as the indicator can stay below the -50 level for a long time. However, values above +50 indicate an overbought condition during a pullback, which may suggest that the next downswing may be about to start.

What timeframes work best for the Chande Momentum Oscillator?

The timeframes that work best for the Chande Momentum Oscillator will depend on your strategy, trading style, and ultimately, your backtesting results. If you are a day trader, you may want to trade on intraday timeframes like the hourly, 30-minute, or 15-minute time frame. If you’re a swing trader, the daily and 4-hourly timeframes may be more suitable. However, the only way to know the best time frame for whatever trading style and strategy is to backtest the various time frames for that trading style to see the time frame that offers the best performance.

How does the CMO perform in volatile markets?

The CMO does not perform well in volatile markets, especially if the market is not trending in a particular direction. When such a market is very volatile, the price tends to spike in both directions, without showing momentum in any direction. The indicator will either spike along or stay flat. On the other hand, when a strongly trending market is volatile, the swings become huge and sustained. So, the CMO may remain overbought or oversold — as the case may be — for a long time.

What are the limitations of the Chande Momentum Oscillator?

The limitations of the Chande Momentum Oscillator include:

• The indicator cannot show the direction of the main trend, and as such, needs to be combined with a trend indicator.
• It can give a lot of false signals, especially when the market is choppy.
• It cannot predict a choppy.
• It cannot be used as a standalone strategy, as it needs other indicators or price action analysis with a trendline to form an effective trading strategy.

Can CMO be combined with other indicators for better results?

Yes, the CMO can be combined with other indicators for better results. In fact, it needs to be combined with other indicators to create a reliable trading strategy. A simple combination is with trend indicators, such as moving averages. The moving average will show the direction of the main trend, as well as serve as dynamic support or resistance level, while the CMO can be used to track individual price swings and spot the end of pullbacks — oversold or overbought signals or divergences. That can be the setup to enter a trade in the trend direction and ride the next impulse wave.

How do you set up the CMO in popular trading platforms?

To set up the CMO in popular trading platforms, you first check if the CMO is one of the built-in indicators in the platform. If it isn’t, you have to get a custom CMO indicator and install it on the platform. Then, go to the indicator section of the platform and search for the CMO. Double-click on it to attach it to the chart. A box may pop up where you input your preferred settings.

What is the best period setting for the Chande Momentum Oscillator?

The best period setting for the Chande Momentum Oscillator will depend on your trading strategy and what suits the market you’re trading. You will have to experiment with different period settings to find the one that works best for your strategy and the market you are trading. So, the best way to know is by backtesting your strategy with different settings.

How does CMO compare to the Relative Strength Index (RSI)?

Compared to the Relative Strength Index (RSI), the CMO is a similar momentum indicator. Both try to use higher and lower closes within the chosen period to estimate the momentum. However, while the RSI uses the ratio of the higher closes to the lower closes over the chosen period, the CMO uses the ratio of the difference between the higher closes and lower closes to the total sum of all the price movements over the chosen period.

How do traders use CMO in a sideways market?

In a sideways market, traders use the CMO for a mean-reversion strategy, especially if the price moves within a defined range. They may look to go long at the lower end of the range (support level) and go short at the upper end of the range (resistance level). The CMO can provide the trade signals — an overbought signal or bearish divergence at the resistance level could be a signal to go short, while an oversold signal or bullish divergence at the support level could be a signal to go long.

What is the role of the CMO in a momentum trading strategy?

The role of the CMO in a momentum trading strategy is to provide a trade setup. It shows when momentum is running out of a countertrend (pullback) move so you can position for the next impulse wave in the trend direction. A common setup for a momentum strategy with the CMO is to combine it with a trendline and price action analysis and use it to enter the next price swing after a pullback to a support or resistance level.

How can you backtest the Chande Momentum Oscillator?

To backtest the Chande Momentum Oscillator, follow these steps:

1. Identify and study the markets you want to backest your Chande Momentum Oscillator strategy.
2. Gather the historical data you need for the backtesting and divide the data into in-sample and out-of-sample data.
3. Formulate the CMO strategy you want to backtest and the parameters or settings you need to adjust.
4. Convert the strategy into a trading algorithm.
5. Run your backtesting on the in-sample data and optimize with the out-of-sample data, adjusting your parameters as needed.
6. Evaluate the results of your backtesting.

What are common false signals in the Chande Momentum Oscillator?

Common false signals in the Chande Momentum Oscillator include:

• False zero-level crossovers: This occurs when the market is choppy. The indicator crisscrosses the zero level, moving from negative territory to positive and back to negative without any clear direction.
• False signal line crossovers: This also happens in a choppy market, where the CMO crisscrosses the 9-period moving average signal line.
• False overbought/oversold signals: False overbought signals happen in a strongly trending bullish market, where the CMO can remain overbought for a long time. The same happens in a strong downtrend, where the CMO can stay oversold for a long time.

How do you optimize CMO settings for different assets?

To optimize CMO settings for different assets, you have to backtest your strategy on those assets using different settings to find out the one that works best for each asset. Also, you have to evaluate your results on each asset from time to time to know when to tweak the settings again for better results.

How can the Chande Momentum Oscillator improve your trading results?

The Chande Momentum Oscillator can improve your trading results by showing you when momentum is running out of pullback moves in a trending market. With that information, you can position for the next impulse wave in the trend direction.