What Is Dynamic Momentum Index?
The dynamic momentum index is a technical indicator used to determine if an asset is overbought or oversold. It can be used to generate trade signals in trending and ranging markets. In this article, the dynamic momentum index will occasionally be referred to as DMI for brevity, but should not be confused with the directional movement index (DMI).
- The dynamic momentum index is an overbought/oversold indicator that uses fewer periods in its calculation when volatility is high, and more periods when volatility is low.
- When the indicator is below 30 the price of the asset is considered oversold and when its above 70, the price is considered overbought.
- When the price moves out of oversold territory it could be interpreted as a buy signal, if the price is ranging or in an uptrend.
- When the price moves out of overbought territory it can be used as a short sale signal, if the price is ranging or in a downtrend.
Understanding Dynamic Momentum Index
The dynamic momentum index was developed by Tushar Chande and Stanley Kroll and is similar to the relative strength index (RSI). The main difference between the two is that the RSI uses a fixed number of time periods (usually 14) in its calculation, while the dynamic momentum index uses different time periods as volatility changes, typically between five and 30.
The number of time periods used in the dynamic momentum index decreases as volatility in the underlying security increases, making this indicator more responsive to changing prices than the RSI. This is particularly useful when an asset's price moves quickly as it approaches key support or resistance levels. Because the indicator is more sensitive, traders can potentially find earlier entry and exit points than with the RSI, but it could also be more prone to whipsaws and false signals.
Traders, especially those involved primarily in the equity markets, can is DMI to determine when a retracement is nearing its conclusion in either a trending or rangebound market.
- During a ranging market, traders watch for the indicator to fall below 30, and move back above it, in order to trigger a long trade. They would then sell, when the indicator moves above 70 or approaches the top of the range. They could then short sell when the indicator crosses back below 70 assuming the range is still intact.
- During an uptrend, traders can watch for the indicator to fall below 30 and rise back above in order to trigger a long trade.
- During a downtrend, watch for the indicator to rise above 70 and then fall below it in order to trigger a short trade.
Another indicator that is similar to the DMA is the stochastics oscillator. Both these indicators measure momentum, but they are doing it in different ways and will thus produce different values and trade signals. The DMI automatically adjusts the number of periods used in its calculation based on volatility. The stochastic oscillator doesn't do this. It has a fixed lookback period. The stochastic oscillator also has a signal line, which generates additional types of trade signals. A signal line could be added to the dynamic momentum index as well.
Dynamic Momentum Index Calculation
The formula for dynamic momentum index is:
Dynamic Momentum Index=RSI=100−1+RS100Calculating RS requires a look back period(typically 14) which changes if creating a DMITo calculate how many periods to use for DMI:StdA=MA10 of StdC5Vi=StdAStdC5TD=INTVi14TD defines how many periods to use for each RS valueTD Max=30 TD Min=5where:Std=Standard deviationMA10=10-Period simple moving averageStdC5=Five-day standard deviation of closing pricesTD Max=Use 30 if TD is greater than 30TD Min=Use 5 if TD is less than 5RS=Relative strength
Traders interpret the dynamic momentum index in the same manner as the RSI. Readings below 30 are considered oversold, and levels over 70 are considered overbought. The indicator oscillates between 0 and 100.
30 and 70 are general levels and can be altered by the trader. For example, a trader may opt to use 20 and 80 instead.
As can be seen in its formula, the DMI uses the RSI formula, but incorporates a varying look back period, between 5 and 30 for each calculation of RS, whereas the RSI typically is fixed to 14. To find the lookback period required for each calculation of RS when calculating DMI, use the following steps:
- Calculate the standard deviation of the last five closing prices.
- Take a 10-period moving average of the standard deviation calculated in step 1. This is StdA.
- Divide step one by step two to get Vi.
- Calculate TD by dividing 14 by Vi. Only use integers for the result, as these are meant to represent time periods and therefore cannot be fractions or decimals.
- TD is limited to between 5 and 30. If over 30, use 30. If under 5, use 5. TD is how many periods are used in the RS calculation.
- Calculate for RS using the number of periods dictated by TD.
- Repeat as each period ends.
This indicator is looking at past price movement. It is not inherently predictive in nature.
Dynamic Momentum Index Example
In the chart below, the circled area shows a potential trade setup in Illinois Tool Works Inc. (ITW) using the dynamic momentum index and horizontal price support. As price retraced to test the previous swing low at the start of April, the indicator gave an oversold reading below 30. The trade setup was confirmed when price failed to close below the previous low, and the indicator started to rise above 30.
Traders could place a stop-loss order either below the previous swing low or below the most recent swing low to prevent a loss if the trade moves against them.
Dynamic Momentum Index Limitations
Overbought doesn't necessarily mean it is time to sell, nor does oversold necessarily mean it is time to buy. When prices are falling an asset can remain in oversold territory for a long time. The DMI indicator may even move out of oversold territory, but that doesn't mean the price will rise significantly. Similarly, with an uptrend, the price could stay overbought for a long time, and when DMI moves out of overbought territory that doesn't necessarily mean the price will fall.
While the indicator lags less than the RSI, there is still some lag. The price may have already run significantly before a trade signal occurs. This means that the signal may appear good on a chart, but it occurred too late for the trader to capture the bulk of the price move.
Traders are encouraged to also consider whether the asset is ranging or trending, in order to help filter trade signals. Other forms of analysis, such as price action, fundamental analysis, or other technical indicators are also recommended.