What is the SMI Ergodic Indicator and How to Use it in Trading?

IntermediateNov 12, 2023
The SMI Ergodic indicator helps traders identify trend strength, time entry and exit points, and spot reversals. When used correctly, the indicator can provide reliable signals that help traders make good decisions, minimizing false signals.
What is the SMI Ergodic Indicator and How to Use it in Trading?

Experienced traders use the SMI Ergodic indicator as a technical analysis tool to evaluate an asset’s trend. The SMI Ergodic indicator is used for trend trading, particularly for spotting reversals. Traders value the signals generated by the indicator because it provides reliable signals.

This article will explain what the SMI Ergodic indicator is, how to use it, its benefits, and provide examples showing its use with live market data.

What Exactly is the SMI Ergodic Indicator?

The SMI Ergodic Indicator or Stochastic Momentum Index is a leading indicator that assists traders in spotting trends and reversals by measuring the distance of an asset’s closing price from its previous closing prices.

The SMI Ergodic indicator is unique because it uses the True Strength Index (TSI) and momentum oscillators to generate trade signals. William Bleu developed the SMIE based on the TSI, whose contributions enable the SMI Ergodic indicator to enhance the effectiveness of the TSI. This enhancement allows the SMIE to offer accurate data to gauge price momentum.

The True Strength Index is designed to measure the price trend and is a core part that makes up one of the key components of the SMI Ergodic Indicator, the signal line.

Components of the SMI Ergodic Indicator

The SMI Ergodic indicator comprises two key components:

Stochastic Momentum Index (SMI)

The SMI is the primary component of the indicator, which measures an asset’s closing price and recent price range. The result of the difference between these two values is smoothed using an Exponential Moving Average (EMA) period. The SMI works similarly to the stochastic oscillator, which calculates the difference between an asset’s current closing price and the midpoint (or middle) of the recent high-low range.

The formula for calculating the SMI is:

SMI = (PCDS/APDS)×100 where:

PCDS stands for Price Close Double Smoothed

APDA stands for Absolute Price Smoothed, both of which the difference is calculated by the EMA period

Signal Line (Ergodic)

The signal line, also known as the Ergodic line, is the secondary component of the SMI Ergodic Indicator. The signal line is based on the TSI, represented by another EMA that further smoothens the SMI values. The essence of the additional smoothening is to reduce noise and provide reliable data for stable signals. The signal line helps traders identify the direction and strength of the trend.

The formula for calculating the Signal line is:

Signal line = EMA × TSI.

Some charting platforms provide an additional line on the SMI indicator called the Histogram oscillator, which acts like the MACD as part of the SMI indicator.

On Tradingview, only the Histogram appears when the SMI oscillator is chosen. If the trader uses the _SMI indicator, _only the SMI and signal lines appear without the Histogram Line. A trader can add both tools to the chart to use them simultaneously.

The Histogram Oscillator calculates the difference between TSI and the EMA of the TSI, calculated thus:

Histogram = TSI - (EMA×TSI)

Source: Tradingview

As shown in the image above, the SMI line is represented by the blue line, while the orange line represents the signal line.

The interaction between the two key components, the SMI and the Ergodic line, forms the basis for generating trading signals. Traders typically look for crossovers, divergences, and extreme readings on the SMI and Ergodic line to make informed trading decisions.

Crossovers between the SMI and Ergodic line can signal potential entry or exit points in the market, while extreme readings may indicate reversal or continuation opportunities.

Source: Tradingview

The image shows the histogram oscillator used on the SMI oscillator.

The histogram provides insights into the current trend of an asset. It is used for trend direction. When the bars on the histogram move above 0 readings, it signifies a bullish trend. If the bars move below the 0 readings, it indicates an emerging bearish trend.

The length of the bars also suggests how strong the trend is; little bars could show weak trends, while long bars show strong ones, reflecting the direction of the momentum.

How to Use the SMI Ergodic Indicator in Trading

Setting up the Indicator

The default settings on Tradingview of the SMI line, Signal line, and EMA period are 20, 5, and 5, respectively. These settings can be adjusted to suit a trader’s objective. For example, long-term trend traders can modify the values to 50 or 100 for a broader view of an asset’s trend.

Traders using Tradingview for chart analysis can use the SMI indicator or oscillator at a time, which can be selected from the indicator list or added separately to the chart.

Interpreting SMI Ergodic Signals

Buy Signal

The SMI Ergodic Indicator shows a buy signal when the SMI line crosses over the signal line below the 0 region, and depending on the timeframe it is being used, it indicates an underlying emerging bullish trend. The buy position can be held until a crossover indicates a sell signal before exiting the trade.

Source: Tradingview

Stop loss limits can be placed below the current price low after the crossovers.

Sell Signal

The indicator shows a sell signal when the signal line crosses over the SMI line above the 0 region. It signifies an emerging bearish trend. Traders can swing the position until an opposing crossover of the SMI line over the signal line indicates an emerging bullish trend, acting as an exit signal.

Source: Tradingview

Neutral

The indicator is neutral when the Ergodic line (signal line) neither crosses above nor below the SMI (Stochastic Momentum Index) line. This condition indicates a lack of a strong trend or momentum in the market.

Traders need to identify consolidation periods to detect market indecision and avoid whipsawing.

Risk Management and Trading Strategies

Crossovers

The SMI line and the Signal line crossovers are among the most powerful trading strategies using the SMI Ergodic Indicator to signal entry and exit points. At the same time, the histogram simply shows the current trend. However, combining the crossovers and the histogram readings provides powerful insights into market trend strength.

Source: Tradingview

The chart above illustrates a scenario where a trader can combine the indicator and histogram signals. The image shows a crossover of the SMI line and Signal line below the 0 reading on the SMI Ergodic Indicator of SOL/USDT 2h chart.

The histogram on the SMI oscillator also reads above 0, indicating bullish intent. Combining these two signals can give a trader insights into an impending bullish trend shown by the histogram and an entry opportunity indicated by the crossovers.

Divergence

The histogram oscillator can also be used for divergence trading. Divergence occurs when technical indicators and the price chart give opposing trade signals. For example, a bullish divergence occurs when the price forms lower lows while the histogram oscillator forms higher lows, indicating a potential bullish reversal—the oscillator readings can be measured by examining the length of the bars, as shown below;

Source: Tradingview

Similarly, a bearish divergence occurs when the price makes higher highs while the histogram oscillator makes lower highs, signaling a potential bearish reversal.

Even though the indicator provides powerful signals, traders should always employ adequate risk management strategies to preserve trading capital.

Benefits of Using the SMI Ergodic Indicator

Accuracy and Reliability

The SMI Ergodic indicator provides accurate and reliable trading signals because it combines elements of the stochastic oscillator and the moving average, giving smoother signals and less prone to false positives.

The value readings and crossovers indicate overbought and oversold conditions, which help traders make well-informed decisions concerning taking profits, cutting losses, or waiting for reversals.

These abilities help traders to trust the signals generated by the SMI indicator, to be precise, reducing the likelihood of entering or exiting trades prematurely.

Versatility across Markets

The SMI Ergodic indicator can be applied across various financial markets, including stocks, forex, commodities, and cryptocurrencies, because the indicator can promptly adapt to each market’s unique characteristics. This versatility enables traders to diversify their portfolios since the indicator can be applied to different assets and trading environments.

Other benefits of the indicator include:

  • Enhanced trend direction
  • Reduced noise and false signals
  • Confirmation of trend strength
  • Divergence detection
  • Customization and flexibility
  • Incorporation into different trading strategies

Disadvantages of Using the SMI Ergodic Indicator

As with any trading tool or indicator, the SMI Ergodic Indicator has some limitations.

  • Whipsawing in Range-Bound Markets: The indicator may generate false signals in ranging or choppy markets. Traders may get buy and sell signals quickly (whipsawing), leading to frequent trading and increased transaction costs with no meaningful profit.
  • Subjectivity in Trend Interpretation: Traders may have different ideas of how to interpret or what constitutes a strong signal, leading to subjective trading decisions.
  • Over-Reliance on Indicators: Relying solely on indicators without considering other factors, such as fundamentals or market sentiment, can lead to missed opportunities or increased risks.
  • Periodic Adjustment Required: Traders may need to periodically adjust the indicator setting to adapt to changing market conditions to maintain the indicator’s effectiveness.

Conclusion

Traders should trade in the direction of an asset’s underlying trend, as counter-trading carries increased risk. The SMI Ergodic Indicator can be applied across various financial instruments and offers reliable trade signals.

However, while the SMI Ergodic Indicator offers many benefits, it has disadvantages and limitations. Traders should be aware of these drawbacks and use the indicator as part of a comprehensive trading strategy that incorporates risk management, other technical analysis tools, and an understanding of market context to get the best out of the trading tool.

Author: Bravo
Translator: Cedar
Reviewer(s): Matheus、KOWEI、Ashley He
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