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BASICS FUNDAMENTALS TECHNICALS ROLLING TC-2000 OPTIONS |
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Greetings, fellow Pro-fundity team members -
10-29-99 Page
- Picking up on last weeks introduction to momentum investing, let’s consider exactly what a momentum indicator measures. By definition, momentum is a measure of the velocity of a price move. Follow the figures to help understand the meaning of velocity.
- Look at the figure below and consider the following. When we push our child in a swing, we start at the bottom (point A), a place we might call the “zero position.” We then push the child to some new position (point B). From here we release the child who then swings back through the zero position (point C) to some new position the other way (point D). The cycle repeats itself as we provide a nudge on the other side, again and again.
- The point here is to identify the relationship between speed and position. The greatest speed occurs when the position is the least, and when the position rises to its maximum, the speed for that moment is zero. It is when the swing passes through its “zero position” that we want to get out of the way. This action occurs with any oscillator and momentum (velocity or speed of a price move) is no exception. As we discussed last week, the terms momentum indicators and oscillators can be used interchangeably.
- So what? Look now at the price chart below for one of our recent picks. The price chart is in black and the Relative Strength Indicator (RSI), a momentum indicator, is shown in red. See the discussion of RSI in our new book, “The Provident Investor.” Notice, for instance, how in early July, the RSI reached a max and turned down, signaling a change in the momentum of the price. About mid-July the price chart followed suit and began a downward trend.
- The magnitude of the RSI is a measure of the velocity of the price move. When the indicators reaches a “top,” that signals an overbought condition, meaning the price is likely to suffer a short-term price decline (correction) in the near future. The RSI oscillator ranges from 0 to 100, with a value over 70 considered an overbought condition and under 30, oversold. When the RSI topped out in our example, that signaled the price increase was running out of steam. In many cases, such as this example, the momentum will anticipate the price move. This is an example of the power of momentum investing.
- In the chart above, the 30 and 70 values occur where the horizontal double lines are drawn. This indicator provides a warning sign when the price trend may respond to overbought and oversold conditions, by changing direction. The RSI line, as it signals changes in the velocity of the price trend, becomes an intelligent location to get ready. It helps stack the odds in our favor by helping us ready our positions appropriately. When the risks of a top in a price trend are evident, it is not the time to buy in or to increase existing positions. The reverse is true on the down-side.
- Consider how this requires substantial discipline: As the price of a stock is rising, this is the very time many people want to get on the bandwagon and capture the gains. It is tough to sell when the euphoria of success rings so loudly in our ears. Likewise, who wants to buy when the price is falling? It is easy to see how emotion can thwart the best laid plans.
- A final note: We have discussed only one indicator, the RSI. Our intent in this guidepost is not to provide a system for trading that will rake in the big bucks. As we've said many times, one indicator is not sufficient. We look for consensus from several indicators to strengthen our strategy. The purpose of this guidepost is to provide an understanding of what a momentum indicator (oscillator) is measuring. We will deal with other indicators and provide some strategic options in future guideposts. Stay tuned.
- It is our intent to help our subscribers understand market strategies well enough to make informed decisions and understand the risks.
This Week's Guidepost
Momentum Investing:
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