| GUIDEPOSTS |
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HISTORICAL GL's
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| TUTORIALS |
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BASICS FUNDAMENTALS TECHNICALS ROLLING TC-2000 OPTIONS |
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- We have shown how the principle of momentum is used to predict or to anticipate changes in the price pattern of a stock. It does this by measuring the rate of the price change. As the normal price pattern cycles between its low level (support) and its high level (resistance), the rate of change in price is greatest as price passes through the center or balance point, slowest at the tops and bottoms. That means we can anticipate the price pattern by following the momentum indicator. The value of the momentum indicator lies in its ability to suggest the price change before it occurs. If this works, we have a valuable tool to help time our buys and sells in the market.
- To understand if it “works,” we need to examine the details of the way the indicator is constructed. What is its “equation?” There are as many different ways to measure momentum as there are tickers on the exchanges. Why? Inputs to the indicators are very simple. Technical analysis is based almost entirely upon three inputs; price, time, and volume. That seems simple enough. However, if we had only 10 prices to consider, 10 time frames and 10 volume levels, that represents 1,000 different combinations. Of course it is not that trivial. Indicators require more than just a simple price, time and volume level. Each variable has multiple ways they are used together. For instance, averages of price over time intervals can represent trends, the relationship of a trend to its volume counterpart can say important things about momentum, and there are different ways an average can be calculated, etc., etc. The point here is there are numerous ways price momentum can be measured. We will study the ones we feel important in this series, with the ever-present quest to seek consensus. No single momentum indicator will work all of the time. When we find strength in numbers, with more than one proven indicator telling us the same thing, we can then find comfort that the principle “works!”
- Last week we devoted our study to the interpretation of momentum indicators. This included the use of overbought and oversold conditions (to tell us when a reversal is likely) and divergences (when the momentum does not follow the price, suggesting a reversal in the price trend is probable). We used the RSI (Relative Strength Index) to illustrate these conditions on stock price charts. Lets consider this momentum indicator in this Guidepost.
- Relative Strength Index: This momentum indicator was first described by J. Welles Wilder some 20 years ago and provides unique upper and lower limits identifying overbought and oversold conditions. The oscillator ranges from 0 to 100, with values over 70 considered overbought (when the stock has risen too high and is ready for a correction), and readings under 30 considered oversold (when the stock has fallen too far and is likely to bounce up). The pictures we used last week were taken off TC-2000 screens which made it easy to use the RSI indicator. This week we will use a program available on the web we have discussed in prior guideposts, Investorama. Although this program does not have all the bells and whistles of a TC-2000, the price is right! So, let’s take advantage of it.
- Get into the program on your PC by following the URL and trail indicated: www.investorama.com - Stock PowerSearch - enter ticker MPDI - under Featured Research, select Big Charts (1-10 yrs) - below the chart select “click here for additional charting options” - click on Time Frame, select 6 months - click on Indicators; you get five fields to define your chart settings. Select the following: 1) moving averages - None, 2) Upper indicators - None, 3) Lower indicator 1 - RSI, 4) Lower indicator 2 - None 5) Lower indicator 3 - None. Move up the screen to click on Draw Chart. You should get a chart that looks like this.
- In last weeks guidepost the picture identified the 30 and 70 lines for overbought and oversold limits. In this picture, with the levels shown at 20 and 80, it is more difficult to see where Wilder’s limits are. Another interpretation of the RSI is to simply buy when the indicator crosses up through the mid-point (50) and to sell when it crosses down. The figure is re-drawn below with lines added to help us out.
- To strengthen our point about multiple momentum indicators, lets add another to compare with the RSI. Return to your BigCharts and go to the frame on the left and in Lower Indicator 2, select “Slow Stochastics.” Move up the screen and click on Draw Chart. You should get a picture like this. I have included the lines from the previous chart to illustrate the point.
- Refer to the Technical Analysis tutorial on the Pro-fundity home page for a discussion on the Stochastics. This indicator uses the 20 and 80 lines for the overbought/oversold limits. We have included dashed lines to signify these points. In this example, the two buys and two sells are confirmed by both indicators. The stochastic crossover points provided a better return than the RSI, but the point is there was no real conflict between the two.
- In coming guideposts, we will examine the “equation,” what they actually measure, as we consider several other momentum indicators. This will help us understand how to treat differences when they occur. 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 #5:
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