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Greetings, fellow Pro-fundity team members -
11-5-99 Page
This Week's Guidepost
Momentum Investing #3:
- Last week we showed how a momentum indicator measures the price velocity, or the rate of price change. This indicator (oscillator) will tell us if the current trend is either gaining or losing its momentum. When a price increase begins to slow down, the momentum indicator will tell us, often before it can be seen on the price chart. At the top, the price loses momentum, entering an overbought condition. On the downside, as a trend decreases, the rate will be picked up by the oscillator and tell us when the price enters an oversold condition.
- We chose one oscillator, the Relative Strength Indicator (RSI), to show how this works. For instance, look at the price chart below with the RSI plotted on the same scale for easy comparison. Remember, the 30% and 70% lines on the chart represent the ranges considered overbought (above 70%) and oversold (below 30%). One method of trading with this oscillator is as follows:
- Observe the location of the 30% and 70% lines (where the double lines occur).
- Whenever the red RSI line passes above 70% it is considered overbought. When the line moves back down through the 70% line, that suggests all the upward momentum is gone and a downtick in the price is likely. This point is used as a buy signal.
- Likewise, as the RSI oscillator passes below the 30% line it is considered oversold. This suggests an uptick in the price is likely and the point where it passes back up through the 30% line is a buy signal.
- The chart below would signal two buys and one sell. From the looks of this chart, that would provide a handsome profit.
Look at the examples below to see the value of this momentum indicator:
In this next example, there are two buy signals in August and September without a sell signal in between. This demonstrates a common chart pattern where two crosses of a signal line (or more) will occur before the opposite condition is reached. Many chartists will wait for the second signal before either buying or selling. The following two charts are examples:
Remember, it is the relationship between the red RSI line and the 30%/70% lines that is important, not the price pattern. The position of the price chart relative to the overbought/oversold signal lines means nothing.
Before we leave this discussion with the impression that this strategy will make all our investment problems go away, look at the following price chart:
This example shows the RSI line with virtually no value relative to the price pattern. Most charts look like this! It takes a lot of time and effort, searching chart patterns, to find those that tell a story with the chosen indicators. The RSI, and most other momentum indicators that we will study, do not work as well in trending markets as in trading markets. Sideways moving patterns, with a lot of volume, that cycle between support and resistance levels, are great for the momentum indicators. We have just defined good rollers. We will find a lot of value in our study of momentum investing for rolling stocks.
This last example punches up the necessity of studying more than one indicator with a price chart. Again, we are looking for consensus among indicators. It is better if we have two indicators sending the same message. Three or more saying the same thing, wow! But there are no guarantees. What we're trying to do is stack the deck in our favor, increase our odds for success.
We are playing against a house that has the odds in its favor. Why do I say that? That's what the data says. Three out of four professional mutual fund managers do not beat the Dow! These guys and gals are some of the best. Where does that leave you and I? Let's take a minute to discuss this critical issue.
We are going to have winning trades and losing trades. We just have to control our losses. That means we must keep stops in place to get out of losing trades with every trade we make. No exceptions. We never lose money because some sinister market maker behind the curtain is conspiring against us. We will lose money when we fail to adhere to basic principles we know are important.
There is great value in maintaining a skeptical outlook on the trades we make. Believing that every trade we make can fail will help us protect ourselves from those that do. A positive outlook in this business does not do us any good. It does not help us keep our guard up against the possible risk. This is the one place a positive attitude can work against us. For example, if we just think positively, maybe that stock will stop falling in price and become the ship we've been waiting for.... Emotion can be our greatest handicap.
Rather, we must develop our own belief system to take sure action, without hesitation, avoiding the pressure of our emotions. We must be aware of changes going on around us, flexible enough to redirect when appropriate, and ever learning. You are in the right place, stay tuned.
Understanding:
It is our intent to help our subscribers understand market strategies well enough to
make informed decisions and understand the risks.
We provide TC-2000 tutorials to members. See the Member Login page.
Be diligent...
Take action!
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