In recent months, fundamentals seem to have been thrown out the window as markets continue a relentless climb in the face of revolution in the Middle East, potential threats to oil (NYSEArca:USO) supplies, a double dip in housing (NYSEArca:IYR), unstoppably high unemployment and a new recession starting in Europe. Technical indicators work no better as sentiment, stochastic, negative divergences and RSI all point to a seriously overbought market long overdue for a correction.
Distortions and divergences abound, largely due to the unprecedented levels of government intervention both here at home and around the world and have created a fog through which many investors and traders seem to have lost their way. Some people are sitting on the sidelines, afraid of a significant correction, and so are missing significant profit opportunities, while others are overly bullish and “buying the dips” in what is now widely considered to be a “risk free” environment.
However, in spite of these challenges, I’ve found that by using momentum as a trading indicator in today’s environment, one can still participate in whatever market climate develops.
Momentum is most easily defined as the acceleration rate of a stock’s price. ETFs or stocks that are accelerating rapidly oftentimes continue that directional trend for sometime and become tradable trends and so momentum can be a valuable trading tool in your arsenal.
Momentum can be measured in different ways and over different time periods.
The easiest way to measure momentum is by using moving average crossovers.
The chart below depicts a 50/200 day moving average crossover represented by the red and blue lines in the price chart. This is a commonly used combination to determine market direction. When the short term line blue line moves above the long term red line, the stock’s momentum is positive, and conversely, when the short term line moves below the long term line, the stock’s momentum is negative.
These crossover points are generally considered to be “buy” or “sell” points as the short term line moves above or below the long term line.
Chart courtesy of Stockcharts.com
In the chart above, the Dow Jones Industrial’s (NYSEArca:DIA) short term blue moving average has moved above the long term red line to indicate a “buy” signal and so the intermediate momentum can be clearly defined as being up.
You can use any length of time you want to plot moving averages ranging from minutes to years but one must be consistent and understand what the moving averages are telling you.
Momentum is only valid as a trading tool if your time horizon and trading style match the momentum indicator you’re using.
Therefore, if you’re using short term momentum, your indicator would only be valid for short term price changes and so your trading horizon should be short, as well. Conversely, if you’re using longer term momentum indicators, say monthly, changes in momentum would indicate price movement for periods of one to several months.
A second way to measure Momentum is to use a widely followed indicator, MACD which is shorthand for Moving Average Convergence Divergence, an intimidating phrase that describes the combination of a trend following and momentum indicator.
In other words, MACD is both a trend indicator and a momentum indicator and so by studying it, one can determine if a security is in an uptrend and if its momentum, or price velocity, is accelerating or declining.
In this example of DJIA (NYSEArca:DIA), MACD on the bottom of the graph is climbing and above the “0” line and so prices and momentum are in a clearly defined uptrend. Also, the short term blue line has moved above the long term red line to indicate an upward trend in prices.
Chart courtesy of Stockcharts.com
However, in this chart of the DJIA (NYSEArca:DIA), one can see that MACD momentum is waning which could be an indicator of an impending change in direction and so should be closely watched over the next several trading days.
So in today’s markets that seem bullet proof and like “Teflon” where nothing bad seems to stick, the combination of Moving Averages with MACD can still give you a good picture of a stock’s or ETF’s direction, trend and momentum. This picture can help improve your chances of picking a winner and having a successful investment over the short or long term which, of course, is the goal we seek.
However, the best news is that these same indicators have the ability to help protect us from the correction that one day is sure to come one day when, not if, the Teflon wears off.
Disclosure: No positions in ETFs or stocks discussed in this article.
John Nyaradi is the author of Super Sectors: How To Outsmart the Markets Using Sector Rotation and ETFs.
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