Using momentum peaks as entry points

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Using Momentum Peaks As Entry Points

This is an introduction into one form of MACD wave analysis and how I use it for short term trading. MACD is a well known indicator of market momentum and one that can be used in a wide variety of ways. For now I will focus on one general method that I use on a daily basis. For this method I use longer and nearer term analysis of the MACD to help predict underlying direction and pinpoint high probability entries. I want to be clear so there is no confusion, this not time frame analysis in the sense that I use a longer term chart and a shorter term chart. This is analysis of what the MACD is doing in one time frame but in terms of “now” and “over time”. In that sense the nearer term analysis is what is happening now and in the present whereas the longer term analysis is a view of what is happening over time. If the longer term analysis is bullish, and the nearer term analysis is bearish then it makes sense to think that the longer term momentum will overcome the shorter momentum.

MACD is useful for measuring the trend and its strength but it is also useful for pinpointing entries. Most traders will wait for a crossover of the zero line before entering a trade but I find that to be a little late. By utilizing the perspective of MACD over time in conjunction with what it is doing in the here and now you can capitalize on counter trend movements in a way that could easily double your potential profits from any given market movement. This is not a counter trend strategy, it is a trend, or I should say momentum, following strategy that seeks to target counter trend extremes as entry points. Most signals require asset prices to return to bullishness or bearishness before signaling an entry. Look at the chart below. The MACD signals a trend following buy on a crossover of the zero line. If you look closely though the move began much sooner than the signal. The peak of bearishness, in hindsight, is the best entry point but not one that many traders or gurus will tell you to buy on as it carries more risk.

Looking at what I have marked as the best entry it is easy to see why. At that point the index price is at an extreme low. The caveat is that the MACD at that time is also convergent with the near term down trend and in ordinary analysis would be indicating lower, not higher prices. The thing to keep in mind is that the bearish peak is in the nearer term, in the longer term the trend is up. Once trend is determined only take trades in the direction of the trend until reversal is indicated. On this chart it is easy to see, with the addition of my trend line, that the trend is up but there is additional confirmation with the MACD. Over time MACD is convergent with the trend. Look at the chart below, it is the same chart as the one above but with a different analysis. Notice how the MACD peaks are growing as asset prices are climbing. This indicates an uptrend as well as one with strength. The strength of the up trend a signal that it will continue to at least one more peak which means that the next dip into bearish momentum would be an entry point.

Look again and we can see that the next three dips into bearish momentum did indeed result in positive entry for bullish trades. Each time that MACD dipped into the bearishness, the blue, and then peaked and began to recede a bullish trade could have been entered. Each peak resulted in a 5-7 candle bounce from the trend line and additional confirmation of the underlying trend. At the far right of the chart price action is moving up to another bullish peak. If prices make a new high then this strategy can be used on the next dip as well. If MACD diverges from price it may be time to adjust trade stance.

The trick with this strategy is to utilize strong trends and then to capitalize on counter trend extremes. The trend is what is happening over time while the near term counter trend movements are what is happening now. Additionally, you can employ multiple time frame analysis as well. A strong buy signal on a daily chart could lead to multiple counter trend entries on a shorter time frame chart like the ones I used here.

Momentum Trading – Understand The Basic Strategies

To become a more successful trader, there are some essential rules to observe. One of the most important of these is the maxim, “the trend is your friend”. You’ve probably already heard of this saying, and after all, what trader doesn’t like to ride a trend?

Many traders use momentum trading to take advantage of trends. They do so because they believe that this method can reduce trading risk and enhance their profits.

What Are Momentum Traders?

Momentum investors are usually day traders that take advantage of strong upward or downward price movements. Momentum traders look for entry and exit points within a trend – more specifically, they look out for either reversal or continuation chart patterns to confirm the direction of the trend.

What is a trend?

In our previous article about trend lines, we explained that there are 3 different kinds of trends: bullish, bearish, and flat.

When markets evolve sideways, there is a lateral consolidation, also called a range, mostly happening when market participants are undecided. According to the Dow Theory, an uptrend occurs when prices form higher highs and higher lows. Conversely, a downward trend is defined as a pattern of falling peaks and throughs.

Momentum Trading

It’s often said that momentum trading is based on Newton’s law of motion, where an object in motion is said to stay in motion until external forces change this state. In the same way, when markets are in motion, when they are trending, they tend to stay in motion rather than reverse.

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If prices go up, they tend to keep going up.

If prices go down, they tend to keep going down.

“Momentum traders can benefit from bull markets as well as bear markets”

Simply put, a bull market is characterized by a rise in prices, a period of sustained gains. When markets are going up, there is strong optimism amongst market participants, which attracts more bullish investors. Because investors are hopeful that prices will keep rising, it supports the upward direction of the prices. It’s all about confidence.

Conversely, a bear market happens when prices go down for a continued period of time. Lack of optimism, lower than expected growth, wars, geopolitical tensions, and many other factors can trigger a downward movement. Extreme emotions from market participants can also reinforce the movement, such as panic.

Market Volatility As a Key Indicator

“Momentum trading relies on market volatility to make profits”

It’s all about capitalizing on volatility.

Rather it is within a bullish or a bearish movement, momentum trading takes advantage of market volatility to make short-term profits. Consequently, trading strategies based on momentum have a higher degree of volatility than other strategies, which requires excellent money and risk management.

Use Momentum Oscillator Indicators In Your Trading Strategy

While prices are trading upwards, downwards, or sideways, oscillators usually look like a flat horizontal band plotted below the chart. Peaks and troughs typically, however, appear on the chart and on the indicators at the same time.

Most indicators have a midpoint value – usually a zero line – dividing the range into 2 halves: an upper part and a lower part.

3 Ways You Can Take Advantage Of Momentum Indicators

Oscillators are most useful when their values are located in extreme areas, such as near the upper and lower boundaries. The market is oversold when the reading is close to the lower extreme, while it is overbought when the reading is close to the upper extreme. These situations indicate that prices are vulnerable, and could possibly be about to reverse.

Divergences are also an important warning to take into consideration, as they could indicate that prices are losing momentum and could be about to reverse. Remember that divergence occurs when the evolution of the prices and the indicator “disagree” and evolve in opposite directions.

When crossing above or below the middle line, traders get potential important trading signals in the direction of the main trend. Many traders use the crossing of the zero line, as buying or selling signals. They will usually only buy an asset if the indicator is above the zero line, and conversely if they want to short-sell an asset.

What Are The Best Technical And Mathematical Indicators?

The Momentum Indicator

As John Murphy explained in his book about Technical Analysis, “momentum measures the velocity of price changes as opposed to the actual price levels themselves.” It’s all about determining the speed and the strength of the price movement.

The momentum indicator compares the most recent prices to previous closing prices to determine when prices are going upward or downward and by how much:

M = CP – CPn – where CP is current closing price, and CPn is the closing price of “n” periods.

10 is usually the default setup, as you can see on the daily EUR/USD chart below. If the momentum line moves above the zero line, like in the green circles, then the latest 10 day close is now above the closing price of 10 days ago, which could soon trigger a bullish leg, or confirm it. When the momentum line keeps going up above the zero line, then the bullish trend is gaining momentum and accelerating.

As you can see on the right part of the above chart, while prices were forming higher highs, the indicator line was creating lower highs, which was a sign that momentum was slowing down and formed a bearish divergence.

The Williams %R Indicator

This indicator, developed by Larry Williams, is very close to the way the RSI and Stochastic indicators work, as it spots overbought and oversold zones that could trigger price reversals. The default setting for Williams %R is 14 periods, regardless of the time frame.

As the Williams %R moves between 0 and -100, -50 the midpoint and is an important level to watch.

When the indicator is below -80, then these low readings indicate that prices are very close to their lowest level over the selected period – see the green rectangles in the above chart.

Conversely, when the indicator line is above -20, then these high readings show that prices are very close to their highest level for the given period – see the red rectangles.

Consequently, traders often see a buying signal when the indicator is between 0 and -20 and a selling signal when the line is between -80 and -100. Many traders wait for the line to exit the overbought, or oversold, situation to get a confirmation for trading signals.

The Stochastic (%K%D) Indicator

George Lane, the man behind this indicator, explained that the “Stochastic Oscillator doesn’t follow price, it doesn’t follow volume or anything like that. It follows the speed or the momentum of price. As a rule, the momentum changes direction before price.”

This momentum indicator shows the relationship between closing prices and the high-low range over a given period of time.

The default setting for the Stochastic indicator is 14 periods, and it is computed as followed:

%D = 3-day SMA of %K

With this indicator, it’s easy to identify overbought and oversold situations that could trigger price reversal. Readings above the 80-level mean that prices are overbought and that they could start heading downward – red rectangles. On the other hand, the oversold threshold is below 20 and prices might be about to head upward – green rectangles.

Trading signals can also be spotted when the %K (blue line) is crossing the %D line (orange line). When the blue line crosses below the orange line, there is a bearish signal – especially when the indicator is leaving the overbought situation. Conversely, when the blue line crosses above the orange line, there is a bullish signal.

Will Momentum Trading Work For You?

Because you need moving assets, it’s important to be available to monitor the charts to spot relevant entry and exit points.

In addition, the time horizon is quite short, so it’s an extremely stressful type of trading, which requires focus, discipline, commitment and patience.

Ready to become a Momentum Trader? Here is what you need to focus on.

  • Select your financial asset(s) wisely
  • If you’re using momentum trading with stocks, take into consideration economic cycle, sectors’ strength, seasonality and the performance of the major indices where the stocks belong
  • If you’re using momentum trading in the Forex market, take into consideration monetary policy changes, inflation/employment/growth figures, as well as trade figures
  • Choose the right time frame
  • Use a volatile market, rather than a rangy one
  • Monitor trading volume
  • Follow the economic calendar and the news to catch market participants’ reaction to important statistics and newsflash
  • Apply a favorable risk/reward ratio depending on your trading capital, your risk aversion, and the trading conditions
  • Do not jump into the market too soon, wait for confirmation
  • Do not close your position too early or too late
  • Keep focusing on the charts to spot any market reversals or signs that momentum is slowing down
  • Have a sound entry and exit setups that mesh with your trading style

The Smart Investor content is intended to be used and must be used for informational purposes only. We are not an investment advisor and you should NOT rely on this information to make investment decisions .

Understanding Momentum Indicators and RSI

Every book dealing with the subject of technical analysis devotes at least a couple of chapters discussing both momentum and the relative strength index (RSI). For those of you not familiar with price momentum and the RSI, you need to know that J. Welles Wilder (who created the index in the late 1970s) first wrote about the subject in the classic “New Concepts in Trading Systems.”

To understand how these two indicators can be used together, we must first, for a moment, review each of them.

Momentum Indicators

Momentum is the measurement of the speed or velocity of price changes. In “Technical Analysis of the Financial Markets,” John J. Murphy explains:

“Market momentum is measured by continually taking price differences for a fixed time interval. To construct a 10-day momentum line, simply subtract the closing price 10 days ago from the last closing price. This positive or negative value is then plotted around a zero line. The formula for momentum is:

Momentum measures the rate of the rise or fall in stock prices. From the standpoint of trending, momentum is a very useful indicator of strength or weakness in the issue’s price. History has shown us that momentum is far more useful during rising markets than during falling markets; the fact that markets rise more often than they fall is the reason for this. In other words, bull markets tend to last longer than bear markets. (To learn more, see: Profiting in Bull and Bear Markets.)

Four Commonly Used Indicators In Trend Trading

The relative strength index was created by J. Welles Wilder Jr. in the late 1970s; his “New Concepts in Trading Systems” (1978) is now an investment-lit classic. On a chart, RSI assigns stocks a value between 0 and 100. Once these numbers are charted, analysts compare them against other factors, such as the undersold or underbought values. To reach the best evaluation, experts generally chart the RSI on a daily time frame rather than hourly. However, sometimes shorter hourly periods are charted to indicate whether it is a good idea to make a short-term asset purchase.

There has always been a little confusion over the difference between relative strength, which measures two separate and different entities by means of a ratio line, and the RSI, which indicates to the trader whether or not an issue’s price action is created by those over-buying or over-selling it. The well-known formula for the relative strength index is as follows:

At the bottom of the RSI chart, settings of 70 and 30 are considered standards that serve as clear warnings of, respectively, overbought and oversold assets. A trader with today’s simple-to-use software may choose to reset the indicators’ parameters to 80 and 20. This helps the trader to be sure when making the decision to buy or sell an issue and not pull the trigger too fast.

Ultimately, RSI is a tool to determine low-probability and high-reward setups. It works best when compared to short-term moving-average crossovers. Using a 10-day moving average with a 25-day moving average, you may find that the crossovers indicating a shift in direction will occur very closely to the times when the RSI is either in the 20/30 or 70/80 range, the times when it is showing either distinct overbought or oversold readings. Simply put, the RSI forecasts sooner than almost anything else an upcoming reversal of a trend, either up or down.

[The RSI and momentum indicators are just a few examples among many tools that you can leverage in stock chart analysis. To learn more about the technical indicators that can serve as the backbone of a successful trading strategy, check out the Technical Analysis course on the Investopedia Academy.]

A Demonstration

Both indicators are very reliable on their own, but what would happen if we decided to put the two of them together? The result offers even better timing with our entry and exit points. Let’s have a look.

In the first chart, we have inserted a momentum indicator with a 12-day period. In the second chart, we compare the stock during the same time frame and lay the RSI indicator across the bottom of the space. The RSI in this example is also a 12-day period.

The first look at the stock shows momentum rising over the zero line in the first week of December. We have shown this on the chart with blue up arrows. This entry signal is not long lived, as the momentum turns a week later and heads south in a hurry to finish the year at about the $22 level, shown with red down arrows. The next entry level is not seen until the first week in February of 2003, again shown with blue up arrows. For the most part, the momentum does not fall below the zero line with any conviction from that week on until the week of June 23. During this period of time, the stock price moves from the $21 level to the most recent close of $32.47.

Chart created with Tradestation

The second look at the stock, which shows the RSI indicator, has a slightly different look from the momentum chart above. First off, there is a weak entry point in early January and then a few weeks later a somewhat stronger entry point, which for the most part continues throughout the winter and on into the spring. You can see that, after the blue up arrows (entry points) we have drawn in the early part of the year, there are three sets of red down arrows (exit points) during mid-March, again during the second week in May and again in the third week of June.

It is important to recognize that many traders view the RSI value of 50 to be a support and resistance benchmark. If an issue has a difficult time breaking through the 50-value level, the resistance may be too high at that particular time, and the price action may fall off again until there is enough volume to break through and continue on to new levels. An issue falling in price may find support at the 50 value and bounce off this level again to continue an upward rise in price action. (For more information, see: Support and Resistance Reversals.)

Chart Created with TradeStation

The Bottom Line

This study of this stock demonstrates an interesting look that traders should consider when using oscillators for entry and exit points. In the second chart, the weak entry point in early January is not even reflecting a buy signal in the first chart, which uses momentum. In conclusion, traders should disregard the entry signal. However, the second entry signal issued a few weeks later by the RSI is confirmed a week later with a strong buy signal from the momentum indicator rising above the zero line.

Another important note is that, even though there are three exit signals shown on the RSI chart, the momentum does confirm sell signals, and the stock continues to rise with short-lived pullbacks. The sell signal on the RSI chart during the third week of June is confirmed with the momentum indicator falling off sharply at the same time and dropping below the zero line.

Double confirmation of entry and exit points gives traders a better understanding of whether or not they are getting in or out at the right time. And timing is everything in this game. (For additional reading, check out: What technical indicators best complement the Relative Strength Index (RSI)?)

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