DOUBLE-SMOOTHED MOMENTUM

Originally, we saw that momentum was unbounded and erratic. It is similar to most other trends but not quite as smooth. There is a technique called double smoothing that will turn a questionable indicator into a very valuable one.

The success of double smoothing is that it creates a trendline that has less lag than a moving average. Less lag means that you can react faster to changes in the direction of prices. Double smoothing does this by averaging the momentum rather than the prices.

Momentum is speed. It shows faster movement and more sensitivity than prices. If you take the first difference in prices (a one-day momentum), then you speed up price movement. If you then average the momentum, you smooth out the prices and slow down the speed. First speeding them up and then slowing them down results in no lag.

However, a momentum indicator that is smoothed once is still not quite enough. If we now average the new result, we are averaging something that has already been averaged. We have smoothed it twice. For convenience we use percentage smoothing rather than a moving average. Figure 15.13 shows Microsoft with 20-day and 40-day momentum indicators in the center panel, and a double smoothing of the 20-day indicator in the bottom panel. The double-smoothed indicator begins with the one-day price differences and smoothes them with a 20-day period (smoothing value of .0476). It then smoothes the new values by .0476 again.

This first example of double smoothing does not produce a trendline that is as smooth as a moving average. It also has different value than the original prices; therefore, it can’t be plotted along with prices in the upper panel. That’s not a big problem because we only need to see the direction of the trendline to decide whether prices are going up or down. Most important, the new double-smoothed line does not have a lag. The highest point and lowest point of the trendline in the bottom panel correspond to the highs and lows of the price chart.