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Momentum Indicators
No market can go up or down forever,
and momentum indicators reflect when a price trend may be weakening
or strengthening. These indicators are usually based on a scale from
0 to 100 and produce “overbought” and “oversold” signals. Although
these indicators do not perform well in extended trending markets,
one of their most useful applications is the concept of “divergence”
– that is, prices go in one direction and the momentum indicator in
another. If prices make a new high but the indicator makes a lower
high, for example, the divergence suggests internal weakness that
could signal the end of the upmove in prices.
Stochastics -
The basic premise of the stochastic indicator developed by
George Lane revolves around the position of
the close relative to the high or low of the day. During periods of
price decreases, daily closes tend to accumulate near the extreme
lows of the day. During periods of price increases, closes tend to
accumulate near the extreme highs of the day. The stochastic study
is an oscillator designed to indicate oversold and overbought market
conditions.
Stochastics are measured and
represented by two different lines, %K and %D, and are plotted on a
scale ranging from 0 to 100. Readings above 80 suggest an overbought
situation; readings below 20 an oversold zone. The %K line is the
faster, more sensitive indicator while the %D line takes more time
to turn. When the %K line crosses over the %D line in overbought or
oversold territory, this could be an indication that a market is
about to reverse course.
Some technical analysts prefer the slow stochastic rather than the
normal stochastic. The slow stochastic is simply the normal
stochastic smoothed via a moving average technique. The most
important signal is divergence between %D and price, which occurs
when the stochastic %D line makes a series of lower highs while
prices make a series of higher highs (see black lines on chart
below). This signals an overbought market. An oversold market
exhibits a series of lower lows while the %D makes a series of
higher lows.
When one of the above patterns appears, you should anticipate a
market signal. You initiate a market position when the %K crosses
the %D from the right-hand side. A right-hand crossover is when the
%D has bottomed or topped and is moving higher or lower and the %K
crosses the %D line. The most reliable trades occur with divergence
and when the %D is between 10 and 15 for a buy signal and between 85
and 90 for a sell signal.
Relative Strength Index (RSI)
- The main purpose of the Relative
Strength Index (RSI ) created by J. Welles Wilder Jr. is to measure
the market's strength or weakness. To calculate RSI, you figure out
the average of the up closes and the average of the down closes for
the study period (typically 14 days), then divide the average of the
up closes by the average of the down closes to get a relative
strength figure. Then you add 1 to that relative strength figure,
divide that sum into100 and subtract that result from 100. If all
that sounds complicated, remember that many analytical software
programs do all those calculations for you.
A
high RSI reading, above 70, suggests an overbought or weakening bull
market. Conversely, a low RSI number, below 30, implies an oversold
market or dying bear market. However, blindly selling when the RSI
is above 70 or buying when the RSI is below 30 can be an expensive
trading system. A move to those levels is a signal that market
conditions are ripe for a market top or bottom, but it does not, in
itself, indicate a top or a bottom.
Although you can use the RSI as an overbought and oversold
indicator, like many indicators, it works best when a failure swing
occurs between the RSI and market prices. For example, the market
makes new highs after a bull market setback but the RSI fails to
exceed its previous highs.
Commodity
Channel Index (CCI) -
The Commodity Channel
Index (CCI) was designed to detect the beginning and ending of
market trends by measuring the distance between the market price and
its moving average, providing a measurement of trend strength and/or
intensity. The CCI is calculated as the difference between the mean
price of a market and the average of the means over a chosen period.
This difference is then compared with the average difference over
the time period.
Values of +100 to –100 indicate a market with no trends. About
70%-80% of all price fluctuations fall within +100 and –100, as
measured by the index. Buy and sell signals occur only when the +100
line (buy) and the –100 (sell) are crossed. The way this indicator
works is almost the opposite of how you would use an oscillator
(overbought/oversold) such as the Relative Strength Index (RSI) or
Slow Stochastics.
To trade using CCI, establish a long position when the CCI exceeds
+100. Liquidate when the index drops below +100. Your reference
point for a short position is a value of –100. Any value less than
–100 suggests a short position, while a rise to –85 tells you to
liquidate your short position.
Percent Range - The Percent
Range (%R) technical indicator, often associated with Larry Williams
and called Williams %R, attempts to measure overbought and oversold
market conditions. Like other indicators, %R always falls between a
value of 100 and 0 and measures where the current day’s closing
price falls within the price range for a specified number of days.
The %R study is similar to the Stochastic indicator except that the
Stochastic has internal smoothing and %R is plotted on an
upside-down scale, with 0 at the top and 100 at the bottom. A value
of 0 indicates the closing price is the same as the period high.
Conversely, a value of 100 shows that the closing price is identical
to the period low. A reading above 80 indicates an oversold
condition; a reading below 20 an overbought situation.
On specifying the length of the interval for the %R study, some
technicians prefer to use a value that corresponds to one-half of
the normal cycle length. If you specify a small value for the length
of the trading range, the study is quite volatile. Conversely, a
large value smoothes the %R and generates fewer trading signals.
As with other indicators, selling just because a %R shows a market
to be overbought (or buying just because it is oversold) may take a
trader out of the particular market long before the price falls (or
rises) because %R can remain in an overbought/oversold condition for
a long time.
Momentum
or Rate of Change - The whole group of
momentum oscillators involves the analysis of the rate of price
change rather than the price level. The speed of price movement and
the rate at which prices are moving up or down provide clues to the
amount of strength the bulls or bears have at a given point in time,
a key indicator regarding the viability of a trend and whether it is
about to end or begin.
Momentum can be calculated by dividing
the day’s closing price by the closing price X number of days ago
and then multiplying the quotient by 100. The momentum study is an
oscillator-type indicator to interpret overbought/oversold
situations. By determining the pace at which price is rising or
falling, the indicator shows whether a current trend is gaining or
losing momentum, whether or not a market is overbought or oversold,
and whether the trend is slowing down.
Momentum is calculated by computing
the continuous difference between prices at fixed intervals. That
difference is either a positive or negative value plotted around a
zero line. When momentum is above the zero line and rising, prices
are increasing at an increasing rate. If momentum is above the zero
line but declining, prices are still increasing but at a decreasing
rate.
The opposite is true when momentum
falls below the zero line. If momentum is falling and is below the
zero line, prices are decreasing at an increasing rate. With
momentum below the zero line and rising, prices are still declining
but at a decreasing rate.
The normal trading rule is: Buy
when the momentum line crosses from below the zero line to above.
Sell when the momentum line crosses from above the zero line to
below. Another
possibility is to establish bands at each
extreme of the momentum line. Initiate or change positions when the
indicator enters either of those zones. You could modify that rule
to enter a position only when the indicator reaches the overbought
or oversold zone and then exits that zone.
You can specify the length of the momentum indicator based on your
trading needs and methods. Some technicians argue the length of the
momentum indicator should equal the normal price cycle, but you can
make it more or less aggressive, depending on the market or your
trading style.
-
Strength and
Sentiment Indicators
-
Trend Indicators
-
Volatility
Indicators
-
Momentum
Indicators
Main Trading
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