Demystifying the Chande Momentum Oscillator
Logic, processes, and limitations
The Chande Momentum Oscillator (CMO) was introduced in Tushar Chande’s 1994 book, "The New Technical Trader," co-authored with Stanley Kroll. Chande created the indicator to address some limitations in various other momentum oscillators, such as the Relative Strength Index (RSI).
According to financial analyst John J. Murphy, investors lowly noted the RSI’s “false signals in a sideways or choppy market,” especially because it can “indicate overbought or oversold conditions without a significant price reversal occurring.”
Today, I’m here to help you deep dive into the exact logic, processes, and limitations that fall behind the CMO.
What is the Chande Momentum Oscillator and How Does It Work?
It’s important to thoroughly understand the motivations behind the movements of any technical indicator before utilizing it to guide your investing. In this section, we’ll get into how to the CMO of any stock over a period of time.
Once you’ve settled on a ticker to analyze, step one is to choose a lookback period - this is the range of time that we’ll be pulling data from to calculate this indicator. We define this value as N. Below, a lookback period of 14 in the AMZN stock is shown.
Next, we’ll calculate our gains and losses, which are calculated with the help of daily price changes.
Daily price changes are measured by subtracting the closing price of the previous day from the closing price of the current day. We follow this calculation by separating our newfound values into gains (positive numbers) and losses (negative numbers).
Next, we sum all gains, which are denoted as S_Gain and all losses, written as S_Loss. Be sure to take the absolute value of the summed losses.
Lastly, we apply the CMO formula - shown below - to successfully calculate this indicator!
How to Use the Chande Momentum Oscillator
The CMO is a tool that can be used in many ways to enhance your trading strategy. Here, we’ll explore different tactics to leverage it effectively.
1. Identifying Overbought and Oversold Conditions
One of the primary uses of the CMO is to identify overbought and oversold conditions in the market. The CMO ranges from -100 to +100, with key levels at +50 and -50.
When the CMO is above +50, it indicates that the asset may be overbought.
When the CMO is below -50, it indicates that the asset may be oversold.
When the CMO has graphed above +50 but goes on to break below that line, the market might indicate continued bearish movement - this is a sell signal! Consider buying when the CMO crosses above -50 from below, indicating a potential upward movement.
2. Divergence Analysis
Divergence occurs when the price of an asset moves in the opposite direction of the CMO. This can be a powerful signal indicating a potential reversal.
Bullish Divergence: Occurs when the price makes a new low, but the CMO makes a higher low.
Bearish Divergence: Occurs when the price makes a new high, but the CMO makes a lower high. This suggests a weakening upward momentum and a potential downward reversal.
Bullish Divergence suggests a weakening downward momentum and a potential upward reversal - consider buying here! Consider selling in the event of a Bearish Divergence - it suggests a slowing upward momentum and a downward reversal.
CMO Analysis
Part 1: Classifying Terms
In this analysis, we’ll be breaking down the CMO into two separate indicators: The Bearish CMO Indicator and the Bullish CMO Indicator.
But, why are splitting the indicator into two?
The market is bound to have vastly different reactions after a low low-point and a high high-point - therefore, investors should react in various ways as well! Please note that this is an analysis of the CMO indicator in only the AMZN ticker! Results may or may not vary vastly from ticker to ticker.
We’ll deep dive into how reliable each indicator is and what you should look out for as you explore the Chande Momentum Oscillator.
Part 2: Reaction to Bearish CMO Indicator
Essentially, we know that we expect to see a strong Bearish trend after this indicator - which has passed above the +50 line - is flashed.
First, we located each Bearish CMO Indicator from January 2021 to December 2023. For each of these signals, the percentage change in the closing price was calculated for the subsequent 10 trading days. These average changes were plotted on the graph to visualize the typical price movement following a bearish CMO signal.
The graph shows a steady decline in the average closing price for the first 10 days after the CMO rises above +50, with the price dropping more significantly around the fourth to sixth trading days. This consistent downward trend indicates that a high CMO value is a reliable bearish indicator for short-term price movements.
Investors! You can reasonably expect a decline in stock price following a high CMO signal, making it a useful tool for anticipating short-term bearish trends. Look out for the Bearish CMO Indicator as potential sell signals or opportunities to short the stock, while also being aware of other market conditions and factors that could influence price movements!
Part 3: Reaction to Bullish CMO Indicator
The graph below was formulated in the same way as the Bearish Indicator, but we recorded events where the COM broke below the -50 line. Here, we expect to see an average Bullish trend.
The graph shows the average change in closing price over the first 10 trading sessions following a bullish Chande Momentum Oscillator (CMO) indicator for Amazon (AMZN). Initially, there is a decline in the closing price for the first five sessions, reaching a low around the fourth session. However, the price then begins to recover, showing a significant upward trend by the tenth session.
This indicates that the reliability of this indicator isn't great, as the initial bearish momentum suggested by the low CMO value is not sustained. Investors should be cautious when interpreting low CMO values as they may not consistently predict prolonged bearish trends, and instead, look for additional confirmation before making trading decisions.
Part 4: Comparison and Findings
The analysis of AMZN’s stock performance following bearish and bullish CMO indicators reveals distinct market reactions. The mixed reliability indicates that investors should use the bearish CMO indicator for predicting short-term bearish trends but interpret the bullish CMO indicator with caution, supplementing it with additional analysis to account for potential price recoveries.
To solve the problem of certain indicators (such as the RSI) producing false signals in sideways markets, Tuscar Chande successfully created an oscillator - the CMO - that shows strong reversals after reaching overbought or oversold conditions. I encourage you to explore this oscillator more deeply in your investments!
Thank you for tuning in today and stay tuned for more posts just like this. While you wait, check out our debrief of Bollinger Bands and how they can help investors, just like you, below!
Be sure to trade smart and stay sharp! Until next time!
(Please note: This article is for informational purposes only and should not be construed as financial advice.)