Number 4
The
Momentum Oscillator
This
month in the ChartFilter Newsletter we'll focus
on the use of the Momentum indicator, one of the
most basic applications of oscillator analysis.
Momentum measures the speed or velocity of price
change and provides a leading indicator of changes
in trend. Analyst and author John Murphy writes
in his book "Technical Analysis of the Financial
Markets," that, in general, oscillators are
most useful when the following three types of signals
are observed:
- Extreme values:
When the oscillator reaches extreme highs or
lows it is signalling overbought and oversold
conditions (see the ChartFilter online glossary
if you would like to know more about these and
other terms).
- Divergence
from the price: a wide divergence is usually
warning of an important change in price trend.
- Centre-line
crossings: provide an important signal regarding
the direction of the price trend.
Please
note that we have used historical data. These
examples are for educational purposes only.
CURRENT
TRENDS - Learning from Sector Indices
The indices
for the various Sectors can provide valuable insights
into the relative health of the market as represented
by specific groups of stocks. In this issue of the
ChartFilter Newsletter we'll look at a couple of
indices and compare them using the Momentum Indicator.
As you will see from the comparison there are some
interesting and potentially profitable differences
between the Computer Software Index and the NASDAQ
Financial Index. What does momentum tell us about
these two indices? Let's take a look at the charts...
First of
all let's look at a one-year chart of the Computer
Software Index.
From this
analysis, it becomes apparent that the outlook is
relatively bearish for the Computer Software sector.
This does not mean, of course, that the shares of
each and every software company will perform poorly
over the coming months. It does, however, give us
one more important clue to consider when looking
at the various sectors to determine which would
offer the best potential for making profits over
the next few months.
Now,
let's look at the Financial Index. (This time
we're looking at a six-month chart, just to emphasize
once again the usefulness of considering different
time periods in your analysis of any market.) As
a side note, the first step in my analysis always
consists of drawing in the mid- to long-term trendlines
on the price chart (the blue lines in these examples)
before contemplating the indicators themselves.
In
this example, I've shown the benefit of using the
Momentum Indicator along with its Moving Average.
In this case the 20-day MA provides a signal line.
When the Momentum line crosses up through the MA
we have a buy signal (green arrows)... when it crosses
down through the MA we have a sell signal (red arrows).
You can see that historically this system has provided
a fairly reliable set of signals.
Below the
Momentum chart, I've also charted MACD. You can
see how the MACD signals confirm those provided
by Momentum. (Please note that MACD and Momentum
are both based on calculations involving price and
time - so they offer slightly different views of
what is basically the same data - this is not as
useful as using a complimentary indicator such as
On Balance Volume (OBV) or Price Volume Trend (PVT)
which also incorporate volume data.)
We can see
that, in comparison to the Computer Software Index,
the Financial Index looks much healthier. It is
in a definite uptrend, as confirmed by both Momentum
and the MACD indicators. The price has recently
broken up through the long-term resistance level
at 1,740 - which, combined with all the other indications,
is a very bullish signal. As an overall sector,
financials appear poised to makes some further gains
over the coming months.
I recommend
that you consider the various sector indices before
investing a sizeable amount in any one stock. When
you have so many sectors to choose from, why not
go with a sector showing a healthy uptrend along
with healthy momentum? This type of analysis will
also give you valuable insights when considering
index or sector funds.
TIPS
& TECHNIQUES - Using Momentum
Momentum
measures the speed of price change.
- The Momentum line
leads price action frequently enough to signal
a potential trend reversal in the market.
- Momentum indicators
can warn of dormant strength or weakness in
the price well ahead of the turning point.
- At extreme positive
values, momentum implies an overbought position;
at extreme negative values, an oversold position.
For additional
information on the use of this indicator see the
ChartFilter.com report on Momentum.
PROFIT
POTENTIAL - Dendrite International, Inc.
Dendrite
International, Inc (DRTE) provides a good example
of a stock that would have yielded excellent profits
over the past five months, primarily using the Momentum
indicator to provide buy and sell signals. Here
I've illustrated a very useful trading system based
on using Momentum and its Moving Average. Currently
DRTE looks like it may be poised for a further upward
move in the near future... take a look at the chart
to see how I've arrived at this conclusion.
The system
I have illustrated here is based on the following
signals (marked on the chart with Red arrows for
Buy and Green arrows for Sell):
- Buy signal
- when Momentum crosses upward through its MA
it is offering a buy signal. Before acting on
this signal, I like to wait for confirmation
when Momentum subsequently crosses upwards through
the zero or centre line (if it hasn't already
crossed). (See Point A on the chart above.)
- Sell signal
- when Momentum crosses down through its MA
it is offering a sell signal. Since I'm always
keen to lock in profits, I usually act on this
signal immediately without waiting for Momentum
to fall further through the zero line.
Currently
DRTE appears poised to break up through both its
MA line and the zero line (see Point B in the chart
above). The price pattern (upper chart) is in a
long term uptrend and has formed a nice triangle
formation. If Momentum breaks upwards and the triangle
pattern is broken on the upside you have a series
of confirming bullish signals.
This
Momentum/MA system has proven reliable to many traders
in the past. Don't forget to combine this system
with trendlines and trend analysis to ensure that
you are trading with the overall trend. Properly
applied, it can yield great results!
Putting
ChartFilter into Context
ChartFilter
is meant to complement your overall trading knowledge
and decision-making. This newsletter focuses
on applying technical analysis (TA) methods
to various markets; but this is not to say that
you shouldn't be considering important fundamental
criteria, such as EPS or revenue, as well. Think
of ChartFilter as your TA assistant; not as your
overall trading strategist.
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