Technical Indicators Tutorial : 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.