Momentum is an interesting concept for traders and investors because it is a leading indicator. In other words it does what we all want to do which is to predict when the trend of a share price is going to change, not just spot it when it has changed.
THE INHERENT WEAKNESS IN MOVING AVERAGES
If you look at moving averages (the average of share price over the past X periods), all they do is re-present the past share price. For those that don’t know, a moving average simply averages the past, say 12 days, of share prices and in so doing “smoothes” the share price chart so you are not chopping and changing your view of the trend every day. If that average price then starts to drop it is more suggestive that a downtrend is starting than just watching the price change on a day.
Traditionally technical gazers use a 12 and 26 period moving average and when the short term moving average crosses through the longer dated moving average it indicates a change of trend and is a signal to now sell or buy.
You can see in this chart of the ASX 200 the 50 day and 200 day moving averages. Whilst most traders would use 12 and 26 day moving averages and investors 12 and 26 week moving averages, the 50 and 200 day moving averages are generally used to identify a “Death cross” or “Golden Cross” – supposedly strong signals to buy or sell the market. You can see a Death Cross in 2015 and a Golden Cross in 2016 marked.
All very interesting but the truth is that a moving average, like many indicators simply looks backwards. In so doing a moving average is always telling us what we can probably already see, that the share price is falling and by the time the moving averages cross, giving you a technical signal to buy or sell, the share price is often long gone. You can see that in this case both the Death Cross and the Golden Cross were 4-5 months behind the action. Moving averages has no real predictive qualities, it is simply a statement of past facts.
The fact that these signals get glamorous names that the media love, like Death Cross, and the Four Horsemen of the Apocalypse (when the Dow Jones, S&P 500, NASDAQ and Russell 200 all create a death cross simultaneously) doesn’t mean they are any more credible or useful as a trading tool because essentially moving averages represent trend changes that have already occurred and may not be indicative of the future at all. They are also, by definition, behind the action.
We want something that is predictive not historic, something that starts ringing the alarm bells that a trend change is underway before it happens, or at least a lot earlier.
This is where Momentum indicators come in.
Momentum is about the ‘rate of change’ of a share price. It is still historic I’m afraid because it is calculated using four data points, the high low open and close, but it is predictive in that it identifies a slowing in the share price trend before the top or bottom occurs.
To explain momentum simply, imagine a ball thrown up into the air. The share price tells you how high the ball is but the momentum tells you whether it is slowing down or speeding up. Before it reaches the top for instance, the share price (the ball) is still going up, but a momentum indicator will tell you it is slowing down and in so doing has (supposedly) predictive qualities, predicting the top. It is based on the premise that if the momentum of the trend is slowing then a change of trend is imminent. Notably it rather relies on share prices trending, that a share price that is already rising will continue to rise…which sometimes they do and sometimes they don’t (most notably when you get shock announcements).
You can now see, that armed with this logic, the technical analysts can now go nuts developing momentum based equations that purport to identify fool proof technical buy and sell signals and, if they can just change the equation slightly to be ‘better’ than the basic equation, who knows, they can maybe give them glamourous names, or name them after themselves, and claim the credit. I’ve always had a bit of a hang up about someone claiming the credit for a sequence of rather basic Maths. I’m not sure you can really do it, but they do.
HOW DOES IT WORK
Looking at momentum on a chart requires a slight adjustment of the brain. Whereas you are all used to share price charts that rise when a share price goes up and that fall when a share price goes down a momentum indicator can fall or rise when the share price is rising or falling. It is about the share price speeding up or slowing down not rising or falling.
And in understanding the difference between a momentum chart and a price chart you begin to understand the relevance of a term you have probably heard before – Divergence. Divergence is when the momentum is slowing down but the price is still going up (or down). Divergence, or contradicting price direction and momentum is the predictive signal we are looking for. You get out of a trend when it is slowing down and get into a trend when it is accelerating. Momentum charts will identify those moments.
Momentum is the rate of change. To measure that the maths simply looks at the closing price and subtracts it from the price say 14 days ago. Repeat every day (12 days is the usual lookback period - the longer you go back the smoother the line - go back over to shorter period and momentum will rise and fall so rapidly that you can’t see any signals). Follow that through and you will see that if the share price is the same as it was 12 days ago the Momentum is zero. If the gap in price is getting smaller the price is slowing down, if the gap is getting bigger it is going up and if the gap is negative the price is falling and if its positive the price is rising.
Now you can put a Momentum indicator on a chart this is a chart of Mayne Pharma (MYX) which is a new trade in our trading section today. The Momentum indicator is at the bottom of the chart. You can see that momentum has turned positive recently.
This is a fairly basic representation of momentum. A more accepted representation is working on percentage change rather than actual change and to do that you divide the close by the close 14 days ago and multiply by 100. This means the momentum of a stock that rises from 10c to 100c in 14 days registers the same value as a stock that moves from 20c to 200c instead of twice as much. This gives you a comparable ratio expressed in percent rather than a number in cents. It looks pretty much the same but the centre line is at 100 instead of 0 and you can measure the relative momentum of two different stocks.
With this momentum indicator you can also get a feel for the range that a particular stock moves in. For instance the momentum of the average move in Telstra is a lot less than the momentum of Bellamys. This percentage measure will make that clear. That helps you identify risky (volatile) stocks from boring (safe?) stocks.
When you multiply an indicator by 100, you create what is called and Oscillator. Don’t get too confused by that, it’s simple enough. It just means that the indicator has been ‘normalised’ which means made ‘normal’ rather than specific to that particular stock. The advantage is that you can compare normalised indicators on a stock to those same normalised indicators on other stocks.
So now we are talking about Momentum Oscillators…a term you may have heard but not understood.
When you look at Momentum Oscillators (MO) there are a few things to know:
- Momentum is a tool for assessing the strength of the trend. It tells you when the trend is slowing down but does not always lead to a share price reversal. It simply tells you that the trend may consolidate or reverse.
- The basic rule is that you buy when the Momentum indicator crosses above the midline at 0 or 100 moving to the upside and sell when it crosses below 0 or 100 moving to the downside.
- MOs are not a stand-alone buy/sell indicator but are used to confirm other signals and feed into a buy or sell decision rather than dictate one.
- Stocks tend to have their own momentum “habit”. For instance, they may see higher momentum in downtrend than an uptrend. This tells you that it is a stock that falls hard and rises slowly.
- A horizontal MO doesn’t mean the share price has stopped rising or falling it means the acceleration or deceleration of the current trend is zero. It can still be going up or down but it’s just not accelerating or decelerating.
- A rising and positive MO means the momentum of the uptrend is increasing (buy).
- A falling but positive MO means the momentum of the uptrend is fading (get ready to sell).
- A falling and negative MO means the momentum of the downtrend is increasing (sell).
- A rising but negative MO means the momentum of the downtrend is slowing (get ready to buy).
- An MO crossing up through the midline at 100 (or zero for some) means the momentum of the trend has changed from down to up.
- An MO crossing down through the midline at 100 (or zero for some) means the momentum of the trend has changed from up to down.
- A lot of the time Momentum indicators mirror the share price movement (which doesn’t tell you much) because like a moving average it is tracking the share price 14 days ago. But momentum isn’t a trend indicator like a moving average it is a measure of how many people are jumping on and jumping off the bandwagon. That can be synonymous with the share price movement, they do move in the same direction most of the time, but what you are looking for is when the two diverge - when the share price is going up but people are jumping off the bandwagon - and now we’re back to divergence. Divergence is when momentum moves in the opposite direction to the share price trend. This is an example of momentum confirming a price rise and momentum diverging from the share price which suggests the share price could reverse.
The most common momentum indicator is one members are probably quite familiar with already – RSI - or the Relative Strength Index. We include RSI on most of our charts.
RSI’s formula is below for the record (you don’t need to dissect this):
The formula is such that the maximum it can hit is 100 (a rapid rise at the maximum point of acceleration) or zero (a rapid fall at the maximum point of acceleration). It ranges between 0 and 100 with 50 being the midpoint.
The way RSI is used in the market is a bit arbitrary. When the value of RSI crosses above 70 or below 30 a stock is declared as being overbought (over 70) or oversold (under 30) which by implication suggests that it is accelerating so hard in one direction it is very likely to slow down in which case it may reverse.
Oversold stocks go on a traders list of stocks to potentially buy and overbought stocks go on a traders list of stocks to potentially sell.
RSI is seen as a leading indicator of a trend change. It is called an oscillator because the indicator readings are normalised, converted into percentage results which range from 0% to 100%. The position of each day’s indicator reading gives the trader an indication of the strength, or weakness, of the existing price trend and whether it is accelerating or decelerating.
It is calculated by monitoring changes in the closing prices of a stock. The number of higher closes is compared to the number of lower closes for the selected period. The RSI its said to measure the “internal strength” of a stock trend by looking at the average of the upwards price changes and comparing it with the average of the downward price changes. These results are then expressed as a percentage which by definition has an upper boundary of 100% and a lower boundary of zero %.
The plotted results oscillate between these two extremes and give traders information about the speed and acceleration of share price changes. Traders usually use either a 14, 9, or 7 day or week period in the Relative Strength Calculation. The over-bought and over-sold signals with an RSI are traditionally set at 70% and 30%.
EXAMPLE – Here is a typical example using a Marcus Today chart…of Dominos Pizza (DMP) which has been taking a bit of a dive recently – everybody wants to catch the bottom. RSI tells us it has already happened.
You can see the RSI buy signal - moving from below 30 (oversold) to above 30:
The RSI sub-chart is show below the share price chart.
- When the red line goes under 30 it is oversold, but you don’t do anything about it until it moves from below 30 to above 30 (RSI crosses up through 30) - that is a technical BUY signal.
- Where the red line goes above 70 the stock is overbought but you don’t do anything about it until it drops from overbought (above 70) to below 70 again - that is a SELL signal.
RSI signals are often wrong. No-one would trade on RSI alone, it is not that good an indicator on its own. But combined with other technical indicators it is however a useful leading indicator of a potential change in share price trend and is good at highlighting stocks worth going to have a look at. Youy might noptice in here that MACD is also on the verge of a buy signal. Two signals at once…time to check the stock and make a decision.
You will find the RSI charts on the bottom of most of our charts and we refer to it a bit in the TRADING PORTFOLIO section.
RSI’s are quote on a daily basis and a weekly basis. They are good for highlighting oversold and overbought stocks that could change direction. You will see we quote RSI for all All Ords stocks in the MARCUS TODAY ALL ORDS SPREADSHEET. You can sort the stocks using RSI into the most oversold and overbought and then start looking for oversold quality stocks and wait for the RSI buy signal.
For more on RSI and how to use it CLICK HERE
Momentum trading is when you trade stocks on momentum without regard to fundamentals. In the tech boom for instance, if you had been using fundamentals alone you wouldn’t have bought a single tech stock. Smart idea. Or was it?
In the late 90’s early 2000’s I was at Bell Securities and the tech boom was getting underway. In the US the NASDAQ index went up 291% in one year. In Australia the market went up 41% in three years and some stocks went up many hundreds of percent.
At the time we had on the desk an adviser who had lived through the Poseidon boom. He spent every morning meeting and every moment on the phone telling us and his clients that it would all end in tears and not to touch the tech stocks.
He was right, but for three years we made a fortune for ourselves and our clients and he did no business whilst actively denying his clients one of the best money making opportunities in the stock market in their lifetimes.
Trading the tech boom was momentum trading. Ignoring the fundamentals and going on share price momentum. Sometimes momentum takes over from logic and fundamentals, but rather than stand on the sidelines and wag your finger from a pious holier than thou fundamental safe ground, momentum trading allows you to exploit the opportunity and get out. Momentum traders, trading in a void of fundamental justification, need to know their exit not just their entry.
It means taking advantage of the tech boom without having such a long time frame that you go through the tech wreck. A knowledge and observation of the momentum would have got you and AND got you out. Where my colleague went wrong is that he thinks the stock market is about buying shares and holding on forever. Yes it was a mistake for someone who only knows how to buy and hold to buy into the tech wreck because they would never be flexible enough to sell. But for those that plan to exit on momentum as well, its fine.
Even though the tech boom turned into a tech wreck it was not to be feared it was there to be exploited and the only the investors that feared it were those, like my colleague, who has a rather old fashioned and unrealistically long time frame. The stock market is not about investing for ten years, it is too volatile. It is for making the most of the opportunities the stock market presents whenever they appear and on any timeframe.
If you met my colleague now he would tell you how clever he was in the tech boom. But he really wasn’t. His timeframe was too long and quite honestly, he did his clients a huge disservice and as a broker, was probably missing the point of sitting in his desk…to make money for clients when it’s there to be made. Not making long term declarations and doing nothing.
OFFER TO SUBSCRIBE
Go to our subscription page and enter the Promotional Code MTDEAL and see our prices change.
If you are not a Member of Marcus Today then see below why you should become one - Why subscribe to Marcus Today - Its all here: