Good Day All, Last week we talked about the two different kinds of momentum, technical and psychological. We took a brief look at the technical side from the candlestick point of view and made mention of some indicators that can help us see changes in momentum. This week I want to dive a little deeper into the momentum indicators to see if we can get these to help us understand and flow better with the momentum of the markets.
I must preface this subject by saying that I have never been much of an indicator guy as I was taught that only the price matters, you know the old saying “price is king!” My first mentor used no indicators and therefore my first experience was to use only price and volume to determine my stance on a particular trade and this I still believe is the first place one should go to take a stand on a particular stock move, however, I am have come around to see that there is some value in using indicators to confirm what we have come to suspect from the price movement. I will also say that the reason my first mentor had no use for indicators is that he knew that they are all fallible in their own ways and therefore should not be used by themselves to make trading decisions. A good example of this is the RSI indicator, a few folks would say that if the RSI is above 70 that is oversold and that it is due to turn over and head down and this is technically true but what they sometimes fail to say is that this condition can remain overbought for long periods of time and if you have jumped into a trade and anticipated a turn that doesn’t come then you may get hurt by both the passage of time and the continued run of the price action. Think of buying a put option in anticipation of a price turn down and it doesn’t happen right away, Theta will start to erode the premium in that option and then Delta will add to the pain by moving against your position. This is the best example I can think of, of why we don’t just use one indicator.
Since we have started with the RSI then we might as well “keep on truckin” with it. The RSI is an oscillator indicator that can tell us overbought and oversold conditions. As I said up top if the indicator is above the 70 mark then conditions are said to be overbought meaning the equity is probably a little overheated. The opposite side of this is the oversold condition and that is when this indicator is below the 30 mark. Again this is telling us that this is stretched to the downside a little. Both of these conditions can be relieved if the equity starts to trend sideways for a period of time and again this could really hurt a directional type of position. It is best not to front-run these types of setups and what I mean by that is instead of just making an assumption that the trend will reverse we can wait until we actually get the reversal candlestick and then the confirmation and then jump in trade. The indicator can act like a big neon sign saying “look at me!!!” but I don’t believe it is prudent to use it for actual trade signals but that is just my point of view. Take a look at the picture below to see the RSI in full view.
You can see from this that it shows overbought and oversold conditions but there is something on the second overbought from the left that should be noted, look how long that went sideways in the overbought state. It appears for the better part of five periods stayed overbought and even climbed in price and depending on one’s exit plan this may have caused the trade to get stopped out prematurely. It is hard to know this exactly as there is no prices to tell how far it actually moved up but I think it is easy to see that making assumptions based on this indicator alone can be problematic at best.
The above is the typical use for the RSI indicator but I find this to be less useful than the other use for a momentum indicator like the RSI. The other use for this type of indicator is called divergence. What this means is that this indicator can signal when momentum is slowing or increasing and not necessarily a turning point or sell signal or buy signal. I find divergence to be a great way to position ourselves for a turnaround but that same caution goes for divergence as the buy signals and that is you need confirmation before jumping in. Divergence is when the indicator moves in the opposite direction of the equity. This gives us a big heads up that momentum could be changing. Take a look at the chart below and you will see divergence in action.
If you look at the price action of this chart it is heading higher and this is confirmed by the higher highs and higher lows in the price but if we look at the two indicators below you can see that they are making lower highs and lower lows, this is classic divergence and this is a way to get sneak peak at what momentum is doing. Most folks would look at this chart and think that this stock is going to the moon and this is where the momentum indicators can really help out, we can be cautious here and wait to see if this pattern falls or breaks out. With the RSI signaling decreasing momentum and this being a rising wedge pattern which is a bearish pattern then taking a wait and see approach here is not a bad idea.
In the above example, we showed not only the RSI but also the MACD indicator which is also a momentum indicator and in next week’s blog we will go over that indicator and all its uses. We are going to go through a bunch of my favorite momentum indicators over the next little while and then I will put together a video on how to use these to make trading decisions and then we will throw a mock trade or two and see if these indicators can help us out.