Spot price reversals with the SMI indicator

Spot price reversals with the SMI indicator

In this Spotlight post we´re looking at the Stochastic Momentum Index (a.k.a. the SMI indicator) by William Blau. The general idea behind stochastic studies is to use momentum falloffs to predict price reversals. To paraphrase George Lane, the developer of the original Stochastics study, one may compare the phenomenon to a rocket going up in the air: Before it can return back to earth, it must slow down. In other words, momentum usually changes direction before price.

The Blau’s Stochastic Momentum Index incorporates the bar close as part of its calculation. This means that it locates the distance between the close and the midpoint of the most recent price change, normalizing it over the range of the price data. This step improves accuracy with respect to identifying overbought / oversold areas, eliminating many false swing setups.

Comparing Stochastic and the SMI indicator

Both standard Stochastics and the SMI indicator move within a predefined range, however, different scales are applied. A standard stochastic study plots on a scale between 0 and 100 whereas the Stochastic Momentum Index moves between -100 and +100. Furthermore, a conventional Stochastics oscillator uses the 80/20 thresholds to locate overbought / oversold scenarios. The SMI on the other hand, identifies trade setups at the intersection of the -50 / 50 levels.

Spot price reversals with the SMI indicator

For example, if the SMI indicator has been moving below the -50 level and subsequently crosses above that threshold, one may interpret it as a buy opportunity. In contrast, if it has been above the 50 level and then crosses below that threshold, it may indicate a short scenario.

A challenge with most oscillators, including the SMI indicator, is that the fixed scale overbought / oversold areas often become distorted during strong trends. This phenomenon can be addressed by using the Roofing Filter as input, as previously discussed in this Spotlight post.

In the following we will look at how to improve reliability of the SMI even further, aligning the Stochastic Momentum Index with a mid / higher timeframe trend filter, namely the HiLo Activator.

Quick intro on the Gann HiLo Activator

The Gann HiLo Activator was introduced by Robert Krausz as a tool for swing traders in 1998. The initial version described an approach for creating a simple moving average of the previous daily highs and lows.

Later, the HiLo Activator was adapted for intraday trading. It may be characterized as a stop and reverse (SAR) indicator, changing direction once the stop-line has been breached. The indicator therefore can be used as a trend filter and / or trailing stop. During up-trends, a trend change or exit signal will trigger once a bar closes below the low average, i.e. stop-line. In a down-trend, the trend change / exit signal will come into play once a bar breaks above the high average.

There are two options for determining a trend change / breach of the stop line:

  • A close breaks the trailing stop level (default setting). A trend change will then plot after the bar closes.
  • The first tick breaks the trailing stop level (reverse intra-bar). A trend change will then plot immediately and two trailing stop levels will be visible simultaneously.
Spot price reversals with the SMI indicator

Fixed vs. Flexible Offset Multiplier

A significant drawback of the HiLo Activator is that the distance at which it trails the median moving average is too small and cannot be adjusted.  We therefore suggest recreating the HiLo Activator with the Supertrend U11 indicator. You may then increase the value for the offset multiplier to avoid frequent trend changes.

To recreate the HiLo Activator with the Supertrend U11 indicator, first choose the Median as input series in the Data Series box. Then, via the indicator dialogue box, set the SMA as input value for both baseline and offset smoothing and the range as the offset formula:

  • Baseline smooting: SMA
  • Offset Formula: Range
  • Offset smoothing: SMA

The Input Parameters are then set to mirror the original HiLo Activator defaults:

  • Baseline period: 50
  • Offset period: 50
  • Offset multiplier: 0,5
Spot price reversals with the SMI indicator

Align SMI Indicator setups with the HiLo Activator

The Supertrend U11 will now plot the HiLo Activator trend bias via paint-bars, i.e. blue for bullish and red for bearish, and the stop line. If the HiLo Activator is bullish, one may consider long positions when the SMI indicator cross above / below the -50 / 50 threshold as mentioned above.

In a follow-up to this presentation, we’ll review the initial test results for using this approach. In doing so, we’ll compare using the HiLo Activator with the Swing Trend indicator from our premium suite, determining its efficiency in filtering momentum turning points. Meanwhile, our SMI indicator for NinjaTrader 8 is available here: