THE PRICE MOMENTUM OSCILLATOR (PMO) AND RELATIVE STRENGTH

Decision Point's Price Momentum Oscillator (PMO) plays a central role among the analysis tools on our web site, particularly as a device by which we can perform relative strength ranking of various stocks, mutual funds, and indexes; therefore, it is appropriate that we begin our PMO discussion with a discussion of relative strength.

A relative strength index (designated "Price Relative" on our ChartTool indicator menu) is an expression of the strength of a target price index relative to a benchmark price index. A pure relative strength calculation consists of dividing the target price index by the benchmark index, usually the S&P 500, but any price index can be used depending upon the relationship you are trying to examine. The direction of the Price Relative index demonstrates whether the target price index is stronger (up) or weaker (down) than the benchmark index.

The chart below shows the NYSE Composite with a Price Relative to the S&P 500 Index. We have also included a chart of the S&P 500 Index to demonstrate some important points. You can clearly see that the Price Relative was rising from April through most of July 2002, indicating that the NYSE Composite Index was stronger than the S&P 500 Index during that period; however, both indexes were in decline for most of that period, meaning that the NYSE was stronger simply because it was declining at a slower rate than the S&P 500. This demonstrates that, besides relative strength direction, you also need to be aware of the trend of the benchmark index. That the Price Relative of the target index is rising, doesn't mean that the index itself is rising. The Price Relative simply expresses the direction of relative strength and shows us when shifts in strength are taking place. Note the turning points in October 2002 and March 2003.

While this indicator expresses relative strength, it cannot be used to rank various securities and indexes in relative strength order, because one Price Relative calculation has no relationship to any other. This point is demonstrated by the two charts below. These charts compare the Dow Jones Industrial Average to the Diamonds, an ETF that tracks the Dow. Since there is a direct relationship between the Diamonds and the Dow, the movement of their respective Price Relative lines is virtually identical, but, because Diamonds are one-tenth the value of the Dow, the Price Relative calculation for the Diamonds results in an index value one-tenth that of the Dow. So, even though the two price indexes have identical relative strength, the Price Relative values cannot be compared for the purpose of ranking the two in terms of relative strength.

THE PRICE MOMENTUM OSCILLATOR (PMO)

In order to perform relative strength ranking, we need an indicator that is "normalized" in a way that permits such comparisons, so we have developed our proprietary Price Momentum Oscillator (PMO). The PMO is based on a Rate of Change (ROC) calculation that is exponentially smoothed. To calculate an ROC we divide today's closing price by a prior closing price. For example, a one-day ROC would be calculated by dividing today's close by yesterday's close. Since this is an internal ratio calculation (versus external, which uses another price index for calculating the ratio), it returns a result that can be compared to an identically calculated ROC result for any other security or index. Below we have charts of the Dow and Diamonds, but this time with Decision Point's PMO.

Note that, not only are the two PMOs shaped the same, but the absolute value of the two PMOs are also virtually the same -- the small difference of 0.02 shows that the Dow was actually stronger by a minuscule amount. The PMO oscillates in relation to a zero line. Normally, the PMO direction tells us if strength is increasing or decreasing, and the steepness of the trend angle demonstrates the power behind the move. We will discuss this more at a later time, as it is a key element when using the PMO as a momentum indicator that can assist in trading decisions.

As a final clarification, remember that the PMO is an expression of  the internal strength of a specific security that can be used as a tool for relative strength comparisons, whereas the Price Relative is a direct expression of the relationship of one price index to another. Either indicator can be useful in its own right, but the PMO has more flexibility and utility, as we shall demonstrate in later discussions.

Now that we have shown why we use the PMO as a tool for relative strength ranking, it would be logical to demonstrate more fully how we use it in this regard; however, we would first like to discuss its role as a traditional analysis tool because this will ultimately help us more clearly demonstrate its exceptional utility in relative strength analysis.

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