DEFINITION of Dynamic Momentum Index
The dynamic momentum index is used in technical analysis to determine if a security is overbought or oversold. This indicator, developed by Tushar Chande and Stanley Kroll, is very 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), while the dynamic momentum index uses different time periods as volatility changes, typically between five and 30.
BREAKING DOWN Dynamic Momentum Index
Traders interpret the dynamic momentum index in the same manner as the RSI where readings below 30 are considered oversold, and levels over 70 are considered overbought; however, the indicator can oscillate between 0 and 100. 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 a security's price moves quickly as it approaches key support or resistance levels. Because the indicator is more sensitive, traders can potentially find earlier entry points.
Trading with the Dynamic Momentum Indicator
The dynamic momentum index can help traders determine when a retracement is nearing its conclusion in either a trending or rangebound market. Traders can confirm signals that the indicator generates with key support and resistance levels, trendlines and other technical indicators that measure a security's momentum, such as the moving average convergence divergence (MACD) or average directional index (ADX).
For example, a higher probability setup would occur if the dynamic momentum index is giving an oversold reading below 30 and price was sitting on a long-term trendline. To add further confirmation, traders could also require a bullish MACD crossover (when the MACD line crosses above the signal line) before entering a trade. (To learn more, see: A Primer on the MACD.)
Dynamic Momentum Index Practical Trading Example
In the chart below, the circled area shows a high probability setup in Illinois Tool Works Inc. 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. (For further reading, see: How do I use the Dynamic Momentum Index for Creating a Forex Trading Strategy?)