Stochastic Momentum Index (SMI) – Rules, Settings, Strategy, Returns

For swing and mean-reversion traders, tracking the price swings and spotting potential reversals is key to finding trade setups, and the Stochastic Momentum Index (SMI) can be a useful tool in this regard. What do you know about this indicator?

The SMI indicator is a powerful tool that helps traders assess changes in trading volume and potential price trends.

In this post, we will take a look at most of the questions you may have about the Stochastic Momentum Index: what it is, how it works, and how you can use it to improve your trading strategies. Read on!

Key takeaways

• Improved Stochastic Oscillator: The Stochastic Momentum Index (SMI) enhances the traditional stochastic oscillator by displaying both positive and negative momentum, according to the inventor.
• Calculation Basis: It measures the distance between the closing price and the midpoint of the high/low range to determine momentum direction.
• Oscillation Range: The SMI moves between -100 and 100, showing increasing upside momentum with positive values and increasing downside momentum with negative values.
• Better Momentum Signals: Unlike the regular stochastic indicator, the SMI effectively highlights increasing negative momentum when prices decline.
• Overbought/Oversold Conditions: High positive values suggest an overbought market, while high negative values indicate oversold conditions.
• Enhanced with Volume Indicators: When combined with volume analysis, the SMI can help identify strong buying or selling pressure.
• We show you a backtested Stochastic Momentum Index trading strategy with trading rules and settings.
• Please click here for the best technical indicators.

What is the Stochastic Momentum Index (SMI)?

The Stochastic Momentum Index (SMI) is an improved version of the regular stochastic oscillator that is designed to show both positive and negative momentum in the price action.

Created by William Blau in 1993, the indicator uses the distance between the current closing price and the midpoint of the high/low price range to gauge where the price closed relative to the range.

Oscillating between -100 and 100, the SMI easily shows when the momentum is increasing on the downside and when it is increasing on the upside. Positive values indicate that the closing price is higher than the midpoint of the high/low range, which suggests increasing upside momentum.

On the other hand, negative values indicate that the closing price is lower than the midpoint of the range, suggesting that the downside momentum is increasing. This makes for a better signal than the regular stochastic indicator, which does not show increasing negative momentum when the price is moving to the downside.

As with the stochastic oscillator, the SMI helps traders and analysts identify overbought or oversold conditions in the market. High positive values indicate an overbought market condition, while high negative values indicate an oversold market. Also, when used with volume indicators, the SMI can show when there is significant buying or selling pressure in the market.

The lower pane in the following chart shows how the indicator might look on a chart:

Stochastic Momentum Index trading strategy – rules, settings, returns, and performance

Let’s backtest a trading strategy that uses the stochastic momentum index (SMI) – complete with trading rules and settings.

We make the following trading rules:

THIS SECTION IS FOR MEMBERS ONLY. _________________ BECOME A MEBER TO GET ACCESS TO TRADING RULES IN ALL ARTICLES CLICK HERE TO SEE ALL 400 ARTICLES WITH BACKTESTS & TRADING RULES

Commissions and slippage of 0.03% per trade are included.

This is a trend-following strategy, and thus, it works best for assets like gold and Bitcoin (and not for stocks).

This is the equity curve for Bitcoin from 2014 until today:

Trading statistics, returns, and performance (including commissions and slippage) for gold (GLD):

• Number of trades: 384
• Average gain per trade: 1.7%
• Annual returns (CAGR): 67%
• Win rate: 43%
• Time spent in the market: 50%
• Risk-adjusted return: 133%
• Max drawdown: 48%

The strategy is on par with buy and hold (67% CAGR), but has a lower max drawdown. Worth noting is the relatively low win rate. The strategy works even better with a shorter lookback period.

This is the code we used for the backtest (Amibroker):

THIS SECTION IS FOR MEMBERS ONLY. _________________ BECOME A MEBER TO GET ACCESS TO TRADING RULES IN ALL ARTICLES CLICK HERE TO SEE ALL 400 ARTICLES WITH BACKTESTS & TRADING RULES

How does the Stochastic Momentum Index differ from the traditional Stochastic Oscillator?

The Stochastic Momentum Index differs from the traditional Stochastic Oscillator in different ways:

• The SMI uses the distance of the closing price relative to the midpoint of the high/low range rather than the distance of the closing price relative to the low of the range as in the traditional stochastic oscillator.
• The SMI values range between -100 and 100, with positive values suggesting increasing upside momentum as prices close above the midpoint of the range, and negative values suggesting that the downside momentum is increasing since prices close below the midpoint. This is unlike the regular stochastic values, which range from 0 to 100.
• With its positive and negative values, the SMI shows when the momentum is increasing on the downside unlike in the traditional stochastic where you have to decipher that yourself from declining values.

Why is the SMI considered a momentum indicator?

The SMI is considered a momentum indicator because it compares where the current closing price is relative to the midpoint of the price range over a chosen period to the entire price range. This relative measure of the price close location over a certain period offers a good estimate of how the price has changed over that period, which is the definition of price momentum — the rate of change.

Its values range between -100 and 100, with positive values suggesting increasing upside momentum, as prices close above the midpoint of the range. Negative values, on the other hand, suggest that the downside momentum is increasing since prices close below the midpoint. When the momentum reaches extreme levels on either side, the market is considered overbought or oversold, as the case may be.

What are the main components of the SMI calculation?

The main components of the SMI calculation include:

• The relative range: This is the distance between the current closing price and the midpoint of the price range over the chosen period (K). The value is positive if the current close is above the midpoint and negative if the close is below the midpoint.
• The price range: Also called the high/low range, this is the difference between the highest and the lowest price over the chosen period (K).
• Double-smoothed relative range: This is an EMA of an EMA of the relative range. Both EMAs use a certain period (D).
• Double-smoothed price range: Also referred to as double-smoothed high/low range, it is an EMA of an EMA of the high/low range. It used the period (D).
• The SMI Line: This is the product of multiplying 200 by the result of dividing the double-smoothed relative rage by the double-smoothed high/low range.
• The signal Line: This is obtained as an n-period EMA of the SMI Line.

How is the Stochastic Momentum Index formula structured?

The Stochastic Momentum Index formula is structured as follows:

Step 1: Calculating the K-period relative range and K-period high-low range:

RR = Current Close — (High_k + Low_k) / 2

HLR = High_k — Low_k

Where:

High_k = Highest price within a given period K

Low_k = Lowest price within a given period K

RR = K-period relative range

HLR = K-period High-Low range

Step 2: Calculating the double smoothed relative range and double smoothed high-low range:

dsRR = EMA(EMA(RR, D));

dsHLR = EMA(EMA(HLR, D))

Where:

EMA = exponential moving average

D = the period for the double EMA

dsRR = double smoothed relative range

dsHLR = double smoothed high-low range

Step 3: Calculating the SMI and the Signal Line:

SMI = 200 * (dsRR / dsHLR)

Or

SMI = 200 * EMA(EMA(RR, D)) / EMA(EMA(HLR, D))

Signal Line = EMA(SMI, n)

Where:

n = the period for the Signal Line EMA

What is the purpose of using the SMI in trading?

The purpose of using the SMI in trading is to determine whether there is positive or negative momentum in the market and gauge the level of the momentum. This helps to show when there is significant buying or selling pressure in the market.

There is selling pressure when the momentum is increasing to the downside and buying pressure when it is increasing on the upside. This is indicated by the value of the SMI. Negative values indicate that the closing price is lower than the midpoint of the high/low range, which suggests increasing downside momentum. On the other hand, positive values indicate that the closing price is above the midpoint of the range, suggesting a rise in the upside momentum.

The indicator is also used to identify overbought or oversold conditions in the market — high positive values indicate an overbought market condition, while high negative values indicate an oversold market.

How do traders interpret SMI signal lines?

Traders interpret SMI signal lines just the same way they interpret those of the classical stochastic indicator. When the SMI line crosses above the Signal Line, it means that the momentum is shifting to the upside, and when the SMI line crosses below the Signal line, the momentum is shifting to the downside.

The significance of this shift in momentum depends on where the crossover happens. If a bullish crossover happens when the indicator is at the oversold level, it suggests a potentially significant upside reversal. Likewise, if a bearish crossover happens when the indicator is at the overbought level, it suggests a potentially significant downside reversal.

What does an overbought SMI reading indicate?

An overbought SMI reading indicates that the upside momentum has reached an unsustainable level and, as such, the price may be due to reverse or at least pull back. It signals traders who are in long positions to book their profits or at least lock in some of them.

If this happens during a rally in a downtrend, it could be a signal to go short, especially if the price is at a resistance level.

What does an oversold SMI reading suggest?

An oversold SMI reading suggests that the bearish momentum in the market has reached an unsustainable level and, as such, the price may be due to reverse or at least pull back. It signals traders who are in short positions to cover their shorts and book their profits or at least lock in some of them.

If this happens during a pullback in an uptrend, it could be a signal to go long, especially if the price is at a support level.

How can the SMI help identify trend reversals?

The SMI can help identify trend reversals via two signals: divergence signals and extreme overbought/oversold signals. A bullish divergence occurs when the price makes a lower low but the indicator makes a higher low, and it suggests a potential upside reversal. When the price makes a higher high but the indicator makes a lower high, there is a bearish divergence, which indicates a potential downward reversal.

An extreme oversold reading (say beyond -90%) followed by the SMI crossing above the Signal line and rising out of the oversold region could signal a bullish reversal in the right market context. The opposite is also true for a bearish reversal — when the indicator rises beyond the 90 level and turns downward, followed by the SMI crossing below the Signal line.

What are the standard settings for the Stochastic Momentum Index?

The standard settings for the Stochastic Momentum Index will depend on the trading platform, as different platforms may have different default settings. But generally, the default settings are 10, 3, 3 —that is, a K-period of 10, a D-period of 3, and 3 period for the signal line EMA. On the TradingView, for example, the settings are 10, 3, 3, as you can see in the image below:

However, you can change the settings to whatever works best for your trading strategy.

How can the SMI be customized for different trading styles?

To customize the SMI for different trading styles, you have to create SMI-based strategies for the different trading styles. Then, you backtest the strategies on different suitable timeframes while experimenting with different settings to find the best setting for each trading style.

For example, you may find that a 20, 5, and 5 setting works for your day trading strategy on the 15-minute timeframe, while a 10, 4, and 3 setting works best for your swing trading strategy on the daily timeframe.

How do you use the SMI to generate buy and sell signals?

To use the SMI to generate buy and sell signals, you have to combine it with trend-following indicators or other trend tools, such as the trendline. This way, you can identify the direction of the trend and then use the SMI to look for the right signal in the trend direction. You can use the oversold and overbought signals for the buy and sell signals respectively.

In an uptrend, you look for oversold signals to buy the reversal of a pullback for the trend continuation. In a downtrend, you look for overbought signals to sell the reversal of price rallies.

Can the SMI be used with other technical indicators?

Yes, the SMI can be used with other technical indicators, especially indicators that complement it. Being a momentum oscillator, it is best to combine it with a moving average or any other trend indicator. The moving average will identify the direction of the trend and also act as a dynamic support and resistance level where pullbacks may reverse for a trend continuation trade.

Here, the SMI can show you when the pullback has gassed out so you can enter the next impulse swing in the direction of the trend.

What are the benefits of using the SMI in trading?

The benefits of using the SMI in trading include:

• The indicator shows the momentum of the price movement.
• It shows the direction of the momentum — whether the downside or the upside is gaining momentum
• Through its overbought/oversold signals, it can show when the momentum has gassed out
• Its divergence signals can show potential price reversals
• It can be used to create entry and exit signals when combined with other indicators

What are the limitations of the Stochastic Momentum Index?

The limitations of the Stochastic Momentum Index include:

• The indicator cannot be used to identify the direction of the main trend unless you do a multiple timeframe analysis and use the SMI momentum on a much higher timeframe as a guide for the trend direction.
• It has to be combined with other indicators to formulate a reliable strategy
• It performs poorly in a tightly consolidating market

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

Compared to the Relative Strength Index (RSI), the SMI is a smoother momentum oscillator, with fewer false signals. The RSI is more sensitive to price movements and, as such, has too many fluctuating swings.

The reason may be in the way they are calculated. While the SMI is doubly smoothed, the RSI does not even use any smoothening at all.

Is the Stochastic Momentum Index suitable for day trading?

Yes, the Stochastic Momentum Index is suitable for day trading if used with a reliable trading strategy and traded on the right timeframe.

The best timeframes for day trading include the hourly, 30-minute, 15-minute, and 5-minute timeframes. Any SMI-based trading strategy that offers an edge on any of these timeframes can be suitable for day trading.

How can SMI divergence be used for trade confirmation?

To use SMI divergence for trade confirmation, you have to have a strategy for identifying potential price swing points where you have trade setups. SMI divergence compares price swing points to know if the indicator’s swings diverge from the price action.

The presence of divergence suggests a likelihood of price reversal. If this occurs in the direction of a trend or a range-bound market, it can be a confluence factor for a trade setup.

What timeframes work best with the Stochastic Momentum Index?

The timeframes that work best with the Stochastic Momentum Index will depend on the trading style and the result of backtesting.

For example, while the hourly, 30-minute, 15-minute, or even 5-minute timeframe can be suitable for day trading, it’s the backtesting result that will tell you the timeframe that works best for that trading style.

How can the SMI be applied in trending markets?

To apply the SMI in trending markets, you must have a way of identifying when the direction of market trends, such as the use of moving averages or trendlines. When you identify the direction of the trend, you can use the SMI to look for potential trade setups in that direction.

If the market is trending upward, look for SMI oversold signals or bullish divergence for buy setups. In a down-trending market, look for SMI overbought signals or bearish divergence for sell setups.

Is the SMI effective in volatile market conditions.?

No, the SMI is not effective in volatile market conditions, whether the market is trending or moving sideways. The reason is that in such a market, the indicator readings are erratic and cannot be trusted.

The SMI is likely to crisscross the signal line and when they are in the overbought/oversold region, there can be false signals.

How do you avoid false signals with the SMI?

To avoid false signals with the SMI, you have to combine it with other indicators or other forms of technical analysis, such as price action analysis. For instance, you can use the market structure and trendlines to spot the trend and also identify support and resistance levels.

Then, you only look for SMI signals that occur in the direction of the trend and at strong support or resistance levels as the case may be. In a downtrend, you look for bearish signals at resistance levels, and in an uptrend, you look for bullish signals at support levels.

What is the history of the Stochastic Momentum Index?

The SMI was created by William Blau in 1993 to improve on the traditional stochastic oscillator, which has been existing since the 1950s. Developed by George Lane, the stochastic oscillator measures the strength of price movement by comparing the current level of the closing price to the price range over a given period.

In the SMI, William Blau changed the closing price level to the relative range of the closing price to the midpoint of the range and introduced a double smoothening method.

How can beginners start using the SMI in their trading strategies?

To start using the SMI in their trading strategies, beginners have to first learn how the indicator works so they can create reliable strategies with it.

After reading resource materials like this one, they should open a demo account and practice with the indicator until they are used to it.