Making the Momentum Indicator Work for You

When analyzing markets I often use the term "momentum" when referring to the amount of strength the bulls or bears have at a given point in time. This market "momentum" is a key indicator regarding the strength of a trend, or whether a trend is about to end or begin.

When I worked as a market reporter on the trading floors of the Chicago Board of Trade and the Chicago Mercantile Exchange, I (as well the floor traders) had a very keen sense of which camp (bulls or bears) had momentum on their side. This was especially true in the grain pits at the Board of Trade. One obtained this keen awareness by being right on the trading floor, talking with all the market-makers who helped determine prices.

By examining charts, cycles, seasonality and other technical indicators-­and near-term fundamentals--one can also get a good reading on whether the bulls or the bears have the edge in any given market. However, I must admit that when trying to gauge market momentum there is no substitute for working right on the trading floor and talking face-to-face with the market-makers. But very few get that opportunity, so other tools have to be employed. One such technical tool is the Momentum indicator.

The Momentum indicator is a popular technical study. It is easy to calculate and can be applied in various ways. Momentum can be calculated by dividing the day’s closing price by the closing price "X" amount of days ago and then multiplying the quotient by 100.

The Momentum study is an oscillator-type that is used to interpret overbought/oversold markets. It assists in determining the pace at which price is rising or falling. This indicates 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, which is 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 is 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 specify the length of the momentum indicator. You must determine a value suitable to your trading needs and methods. Some technicians argue the length of the momentum indicator should equal the normal price cycle. The best method is to experiment with different lengths until you find the length that works best for that particular commodity you are trading.

Like most other "secondary" trading tools in my trading toolbox, I do not use the Momentum indicator, solely, to generate buy and sell signals, or to gauge the overall technical situation in a market. I use the Momentum indicator to help confirm or refute general ideas I have developed by using my "primary" trading tools, such as trend lines, chart patterns and fundamental analysis.

Important Rules of Technical Trading

1. Map the Trends

Study long-term charts. Begin a chart analysis with monthly and weekly charts spanning several years. A larger scale "map of the market" provides more visibility and a better long-term perspective on a market. Once the long-term has been established, then consult daily and intra-day charts. A short-term market view alone can often be deceptive. Even if you only trade the very short term, you will do better if you're trading in the same direction as the intermediate and longer term trends.

2. Spot the Trend and Go With It

Determine the trend and follow it. Market trends come in many sizes -- long-term, intermediate-term and short-term. First, determine which one you're going to trade and use the appropriate chart. Make sure you trade in the direction of that trend. Buy dips if the trend is up. Sell rallies if the trend is down. If you're trading the intermediate trend, use daily and weekly charts. If you're day trading, use daily and intra-day charts. But in each case, let the longer range chart determine the trend, and then use the shorter term chart for timing.

3. Find the Low and High of It

Find support and resistance levels. The best place to buy a market is near support levels. That support is usually a previous reaction low. The best place to sell a market is near resistance levels. Resistance is usually a previous peak. After a resistance peak has been broken, it will usually provide support on subsequent pullbacks. In other words, the old "high" becomes the new "low." In the same way, when a support level has been broken, it will usually produce selling on subsequent rallies -- the old "low" can become the new "high."

4. Know How Far to Backtrack

Measure percentage retracements. Market corrections up or down usually retrace a significant portion of the previous trend. You can measure the corrections in an existing trend in simple percentages. A fifty percent retracement of a prior trend is most common. A minimum retracement is usually one-third of the prior trend. The maximum retracement is usually two-thirds. Fibonacci retracements of 38% and 62% are also worth watching. During a pullback in an uptrend, therefore, initial buy points are in the 33-38% retracement area.

5. Draw the Line

Draw trend lines. Trend lines are one of the simplest and most effective charting tools. All you need is a straight edge and two points on the chart. Up trend lines are drawn along two successive lows. Down trend lines are drawn along two successive peaks. Prices will often pull back to trend lines before resuming their trend. The breaking of trend lines usually signals a change in trend. A valid trend line should be touched at least three times. The longer a trend line has been in effect, and the more times it has been tested, the more important it becomes.

6. Follow that Average

Follow moving averages. Moving averages provide objective buy and sell signals. They tell you if existing trend is still in motion and help confirm a trend change. Moving averages do not tell you in advance, however, that a trend change is imminent. A combination chart of two moving averages is the most popular way of finding trading signals. Some popular futures combinations are 4- and 9-day moving averages, 9- and 18-day, 5- and 20-day. Signals are given when the shorter average line crosses the longer. Price crossings above and below a 40-day moving average also provide good trading signals. Since moving average chart lines are trend-following indicators, they work best in a trending market.

7. Learn the Turns

Track oscillators. Oscillators help identify overbought and oversold markets. While moving averages offer confirmation of a market trend change, oscillators often help warn us in advance that a market has rallied or fallen too far and will soon turn. Two of the most popular are the Relative Strength Index (RSI) and Stochastics. They both work on a scale of 0 to 100. With the RSI, readings over 70 are overbought while readings below 30 are oversold. The overbought and oversold values for Stochastics are 80 and 20. Most traders use 14-days or weeks for stochastics and either 9 or 14 days or weeks for RSI. Oscillator divergences often warn of market turns. These tools work best in a trading market range. Weekly signals can be used as filters on daily signals. Daily signals can be used as filters for intra-day charts.

8. Know the Warning Signs

Trade MACD. The Moving Average Convergence Divergence (MACD) indicator (developed by Gerald Appel) combines a moving average crossover system with the overbought/oversold elements of an oscillator. A buy signal occurs when the faster line crosses above the slower and both lines are below zero. A sell signal takes place when the faster line crosses below the slower from above the zero line. Weekly signals take precedence over daily signals. An MACD histogram plots the difference between the two lines and gives even earlier warnings of trend changes. It's called a "histogram" because vertical bars are used to show the difference between the two lines on the chart.

9. Trend or Not a Trend

Use ADX. The Average Directional Movement Index (ADX) line helps determine whether a market is in a trending or a trading phase. It measures the degree of trend or direction in the market. A rising ADX line suggests the presence of a strong trend. A falling ADX line suggests the presence of a trading market and the absence of a trend. A rising ADX line favors moving averages; a falling ADX favors oscillators. By plotting the direction of the ADX line, the trader is able to determine which trading style and which set of indicators are most suitable for the current market environment.

10. Know the Confirming Signs

Include volume and open interest. Volume and open interest are important confirming indicators in futures markets. Volume precedes price. It's important to ensure that heavier volume is taking place in the direction of the prevailing trend. In an uptrend, heavier volume should be seen on up days. Rising open interest confirms that new money is supporting the prevailing trend. Declining open interest is often a warning that the trend is near completion. A solid price uptrend should be accompanied by rising volume and rising open interest.

Technical analysis is a skill that improves with experience and study. Always be a student and keep learning.

High Probability Trading

Even traders with limited experience start to realize that we are not trying to capture every market move. We want to improve our odds and reduce our frustration by filtering, for high-probability trades.

The combination of trend and Fibonacci techniques can provide powerful signals for higher probability trading. We already know that trend-lines have some validity, and so do Fibonacci levels. Combine the two, to improve your chances.

The following charts are the GBP/USD. First, the daily chart as of October 5 th 2005. I have drawn a red down-sloping trend-line joining the two recent swing highs.

The chart has moved down since early September , making a down-trend of consecutive "waves" with lower swing highs and lower swing lows. There were several opportunities to take advantage of the down-move. In this tutorial we will focus on the October 6 th opportunity.

In a down-trend we want to short those swing highs, and take profits on swing lows. We don't want to short every time we **think** we have a swing high. If you have tried that, you know about whipsaw and fake-outs already haha. We only want the best trades, those which are more likely to succeed. So how do we choose an optimum entry point?

Our odds are improved if we have a swing high near a down-sloping trend-line (in red on the chart). Markets tend to reverse at Fibonacci levels. So if we have a significant resistance level near a trend-line we have an even better chance of success.

The next chart shows the GBP with Fibonacci resistance levels. Notice the "SK Resistance" level. This represents an area of significant resistance, with a higher probability of a reversal.

If you are new to Fibonacci, those studies look like a confusing series of colored lines. Learning how to use these Fibonacci studies, and which of them are stronger (higher probability), is really easy! I have made two video seminars that explain this.

That "SK Resistance" level, coinciding with a trend-line is an optimum shorting zone. If the market reaches that area (we can't be sure it will), and if the market resists there, we want to take a short position. Once the resistance materializes, it will be difficult for the market to move against us.

Most of us are not trading the daily chart, but we can use the longer-term charts to find **powerful** trends and Fibonacci levels. The next chart is a 60-minute chart. I choose 60-minutes because it clearly shows when resistance has materialized. You may prefer a 30 minute of 5 minute chart.

The following 60-minute chart shows how the Pound rallied to the SK resistance level, and the trend-line. It rallied over those, tested them briefly, then retreated. There are several ways to determine whether resistance has materialized. I have some very powerful techniques for that purpose. However we want this tutorial to focus on some basics. So for now we will use the obvious breaking of the rising trend as our trigger.

During that rally upward, the 60-minute chart has a series of higher swing highs and higher swing lows. Once we broke the highest swing low (see the last bar on the above chart), we know that up-trend has expired. So we want to start shorting rallies and take profits on dips as shown on the next chart (60-minute chart).

Notice how the market broke down, and never looked back! That is what happens when you combine trend-lines with Fibonacci techniques. The best trades go your way and keep on going. That is a characteristic of higher-probability trading.