Traders often use momentum indicators to assess the current state of the stock market. The guiding principle of this analysis is that momentum leads price. This can be seen with a simple example from outside the financial markets, something like running.
If you are running a mile, you might get tired and slow down at a certain point. You may keep going, but you will change the speed you’re running at, slowing before eventually stopping.
Traders believe a similar process unfolds in the stock market. They follow momentum indicators expecting the indicator to slow before the price trend stops and reverses.
Popular momentum indicators include the stochastics, RSI and MACD. All three are shown in the chart of the SPDR S&P 500 ETF (NYSE: SPY) shown below.
Stochastics Is Diverging
Just below price is the stochastics indicator. A market analyst named George Lane is usually given credit for developing the indicator. That is disputed by others and a reading of the history of stochastics shows that there is no clear answer.
No matter who developed the tool, lane certainly popularized it. As he described it, “Stochastics measures the momentum of price. If you visualize a rocket going up in the air – before it can turn down, it must slow down. Momentum always changes direction before price.”
The same idea applies to a golf ball, which many of us are more familiar with. The gold ball flies off the tee and arcs higher, at least when the pros do it on TV. The ball levels off and as it does its momentum slows. Then, it begins to fall and its momentum accelerates to the downside.
Stochastics, and other momentum indicators, apply this idea to prices. Technical analysts generally believe that a close near the high is bullish and a close near the low is bearish. Stochastics quantifies this belief with the formulas shown below.
In the chart above, prices have been making new highs while stochastics has not. This could indicate momentum is slowing. To confirm that, we will consider a weekly chart of SPY and more fully consider the RSI.
RSI is a momentum indicator that measures the magnitude of recent price changes to analyze overbought or oversold conditions. It is primarily used to attempt to identify overbought or oversold conditions in the trading of an asset.
“The relative strength index (RSI) is calculated using the following formula:
RSI = 100 – 100 / (1 + RS)
Where RS = Average gain of up periods during the specified time frame / Average loss of down periods during the specified time frame
The RSI provides a relative evaluation of the strength of a security’s recent price performance, thus making it a momentum indicator. RSI values range from 0 to 100. The default time frame for comparing up periods to down periods is 14, as in 14 trading days.
Traditional interpretation and usage of the RSI is that RSI values of 70 or above indicate that a security is becoming overbought or overvalued, and therefore, may be primed for a trend reversal or corrective pullback in price.
An RSI reading of 30 or below is commonly interpreted as indicating an oversold or undervalued condition that may signal a trend change or corrective price reversal to the upside.
RSI was introduced to traders by J. Welles Wilder in his 1979 book, New Concepts in Technical Trading Systems.
In the chart above, RSI is moving up, but is not giving a decisive buy signal. Using the two momentum indicators, we do not have a clear signal. Hopefully, that can be resolved with a look at the monthly chart and a detailed look at MACD.
Formally, MACD is the Moving Average Convergence-Divergence indicator. It’s been available to traders since at least the 1970s when Gerald Appel began writing about it. The indicator is most commonly viewed as a series of bars, like the ones shown in the chart below.
MACD is designed to identify changes in the direction of price momentum. The chart above shows when momentum is rising or falling and it also shows whether momentum is above or below zero, in other words whether it’s bullish or bearish while showing degrees of bullishness or bearishness.
To find MACD, the calculation begins with two moving averages (MAs). Usually, the 12 period MA and 26 period MA will be used. Other time periods can be used and the calculations can be done with weekly or monthly data in addition to daily data.
The two MAs are calculated and then the value of the longer MA (the 26 day in this example) is subtracted from the shorter MA (the 12 day in this case). Instead of using a simple moving average, traders generally use exponential MAs to find MACD.
An exponential moving average, or EMA, is often thought as being more responsive to the market action than a simple MA. This means the EMA will be closer to the most recent price than a simple MA and should give signals faster.
The formula for MACD is:
MACD = 12 day EMA – 26 day EMA
But, that’s not what is shown in the chart above. MACD is nearly always shown with a signal line, which is a 9 day EMA of the MACD line. The bars in the chart above are found by subtracting the value of the signal line from the MACD.
In the monthly chart, MACD is declining, indicating the trend could reverse. But, a similar pattern formed last year and failed to give a signal. The chart shows monthly sell signals are reliable and if a trader followed just one momentum indicator, the monthly MACD could be the most valuable.
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