Tricks to Trading With the Relative Momentum Index

How to use Relative Momentum Index (RMI) buy and sell signals to inform your stock trading decisions

by Bernie Schaeffer

Published on Mar 7, 2016 at 8:16 AM

The following is a reprint of the market commentary from the March 2016 edition of The Option Advisor, published on February 25. For more information or to subscribe to The Option Advisor, click here.

The Relative Momentum Index (RMI) -- a moving average-based overbought/oversold indicator that can remain overbought or oversold for much longer periods than its fellow members of the oscillator family -- is a factor we often consider when forming trade recommendations. Unlike the more commonly observed Relative Strength Index (RSI), which measures short-term instances in which stocks are overbought (or oversold) that might cause a temporary interruption in the prevailing trend, a high RMI level can often be an indicator of a positive price trend that can persist for many months.

As with the RSI, the value of the RMI oscillates between zero and 100. The calculations for the two indicators are essentially variations on a theme, with the security's average gains stacked up against its average losses to determine the general price trend.

The formula to calculate RSI is based on the security's average one-day gain over the past X days divided by the average one-day loss over this same number of days (with 14 being a very popular value for X). Generally speaking, RSI values above 70 are viewed as an "overbought" indicator, wherein the stock is predicted to retrace some recent gains, while RSI values below 30 are considered "oversold," with the shares then expected to move off their lows.

The key differences in the RMI calculation as compared to its RSI counterpart are the time frame during which average gains and losses are measured, as well as the overall lookback period. Rather than comparing one-day gains and losses, a typical RMI calculation is based on the stock's average five-day gains over the past X days divided by the average five-day losses over this same period. And whereas 14 is the most popular "X" value for RSI, the RMI most frequently uses 20 for this variable.

As with RSI, moves above 70 by the RMI could be considered "overbought," and drops below 30 "oversold" -- but, as noted above, RMI is more likely to flag bullish trends that have the legs to keep going, differentiating these signals from the short-term trend reversals which RSI is often used to pinpoint. In other words, RMI moves above 70 frequently correspond with strong bullish momentum in the underlying stock -- and as such, are often accompanied by a sustained period of upside price action (despite simultaneous overbought warnings from a number of other oscillator-type indicators).

Though we'll discuss a major caveat to these guidelines immediately below, here are the four major RMI trading signals, from our perspective:

  • A move from below to above 70 = Buy
  • A move below 70 = Close long positions (iffy whether or not you want to establish new short positions on this signal)
  • A move below 30 = Short
  • A move from below to above 30 = Cover shorts (iffy whether or not you want to establish new long positions on this signal)

Having said that, some names just seem to naturally trade for extensive periods on signals -- whether above 70 or below 30 -- and others tend to chop around almost as much on their RMI as on their RSI. Our strong lean for directional trading (especially options trading) is to try to focus on the former group, and avoid the latter group.

One recent example of a solid RMI signal is found in the price action of Amazon.com (AMZN). The stock's 20-day RMI rose above 70 last Oct. 16, and crested as high as 91.11 by Nov. 12 -- a period of time over which AMZN shares gained 16.6%. AMZN's RMI first began to lose its grip above 70 about a month later, in mid-December, but the indicator churned relatively close to this level for the next few weeks. On Dec. 29, when AMZN achieved its reigning record-high price of $696.44, its RMI was docked at a borderline reading of 69.79.

The RMI's late-December shakiness around 70 was prescient of a forthcoming pullback in both the indicator and the shares. By Jan. 13, AMZN's RMI was falling through the 30 level, denoting a major momentum shift -- and by the close on this day, AMZN shares were down 16.5% from their newly tagged all-time high.

AMZN RMI 0225

As noted above, we would view RMI moves above 70 as "buy" signals, with subsequent RMI declines below 70 serving as "sell" suggestions for those holding long positions. But as the AMZN scenario above suggests, RMI should not be used for hair-trigger trading decisions. Rather, sustained RMI moves above and below the 70 threshold are most useful for traders looking to take advantage of momentum trends. This mitigates the risk of biting on any RMI-based "fakeout buys" -- in which there is a brief RMI penetration above the 70 mark that's immediately followed by a retreat to well below 70.

But this is not to suggest there's no merit whatsoever to an RMI fakeout buy signal. As close followers of various chart pattern-based technical indicators can attest, sometimes the failed (or unconfirmed) buy signal can be just as bearish in its implications as a realized sell signal. And in fact, one of these fakeout buys occurred on Apple (AAPL) late last May, which was a contributing factor to our recommendation to buy Apple puts in our Weekend Player bulletin service last June. As expected, the failed signal preceded a period of downside for Apple shares, allowing subscribers to achieve target profits on the trade in just under two months.


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