Using momentum analysis to predict price change

September 30, 2009 07:00 PM


Three terms commonly associated with momentum oscillators are overbought, oversold and divergence.

Overbought means that a particular market has felt a lot of buying pressure recently (see “Speed kills the trend”). Available capital to continue buying may be nearly extinguished. If true, the uptrend should stall or reverse. Oversold means the opposite: a particular market has experienced considerable selling and is likely to flatten out or reverse. Divergence refers to the indicator making a lower high or a higher low while price continues to rise or fall, respectively (see “Divided it turns”).

One caveat to keep in mind is that even though the direction of the oscillator’s movement may change, the trend may remain the same. For example, if the ROC reading has dropped from 120% to 110%, the market is still in an uptrend because the percentage is still higher than 100%. Its rate of increase, however, has indeed slowed and may indicate that price is primed for an actual turn.

Unlike rate of change — the more basic calculation of which can theoretically escalate to infinity or drop to zero — RSI will always oscillate between 0 and 100. As prices rise during an extended uptrend, the RSI value will rise as well. Likewise, in a downtrend, the RSI value will tend to drop along with price. Key levels for indicating extreme overbought and oversold conditions are 70 on the high side and 30 on the low side.

In other words, as the RSI value reaches these levels, the market may be overbought or oversold. Still, as with rate of change, it’s important to keep in mind that just because RSI is overbought or oversold doesn’t mean it will stop being so anytime soon. Markets can remain in either condition for extended periods of time — and often do so.

The interpretation of stochastics generally focuses on the relationships between %K and %D. When the fast line, %K, crosses the slow line, %D, a potential change in trend is indicated. A cross below suggests a new downtrend is on tap (“Crossing to the other side" ). A cross above suggests a bullish move is imminent. As with RSI and rate of change, stochastics, particularly in relation to the slowest line (%D), is helpful as a divergence indicator.

Keep in mind that while with hindsight clean, obvious, well-chosen examples can be found, momentum oscillators generally work poorly for initiating new positions. That said, they are considered relatively reliable indicators for foretelling the end of a trend move. In other words, if you’re long and you notice a classic RSI divergence on a higher high, it may be time to take some money off the table, or at least tighten up your trailing stops.

Success, of course, comes down to the big question — whether that high or low value means a continuation of the trend or that a turn is imminent. Either way, opportunity abounds. It’s just a matter of practice, patience and trading with conviction.

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