Stock Diamond - Technical Analysis Education

The Momentum Oscillator

This month in the ChartFilter Newsletter we'll focus on the use of the Momentum indicator, one of the most basic applications of oscillator analysis. Momentum measures the speed or velocity of price change and provides a leading indicator of changes in trend. Analyst and author John Murphy writes in his book "Technical Analysis of the Financial Markets," that, in general, oscillators are most useful when the following three types of signals are observed:

1. Extreme values: When the oscillator reaches extreme highs or lows it is signaling overbought and oversold conditions (see the ChartFilter online glossary if you would like to know more about these and other terms).
2. Divergence from the price: a wide divergence is usually warning of an important change in price trend.
3. Centre-line crossings: provide an important signal regarding the direction of the price trend.

Please note that we have used historical data. These examples are for educational purposes only.

CURRENT TRENDS - Learning from Sector Indices

The indices for the various Sectors can provide valuable insights into the relative health of the market as represented by specific groups of stocks. In this issue of the ChartFilter Newsletter we'll look at a couple of indices and compare them using the Momentum Indicator. As you will see from the comparison there are some interesting and potentially profitable differences between the Computer Software Index and the NASDAQ Financial Index. What does momentum tell us about these two indices? Let's take a look at the charts...

First of all let's look at a one-year chart of the Computer Software Index.

From this analysis, it becomes apparent that the outlook is relatively bearish for the Computer Software sector. This does not mean, of course, that the shares of each and every software company will perform poorly over the coming months. It does, however, give us one more important clue to consider when looking at the various sectors to determine which would offer the best potential for making profits over the next few months.

Now, let's look at the Financial Index. (This time we're looking at a six-month chart, just to emphasize once again the usefulness of considering different time periods in your analysis of any market.) As a side note, the first step in my analysis always consists of drawing in the mid- to long-term trendlines on the price chart (the blue lines in these examples) before contemplating the indicators themselves.

In this example, I've shown the benefit of using the Momentum Indicator along with its Moving Average. In this case the 20-day MA provides a signal line. When the Momentum line crosses up through the MA we have a buy signal (green arrows)... when it crosses down through the MA we have a sell signal (red arrows). You can see that historically this system has provided a fairly reliable set of signals.

Below the Momentum chart, I've also charted MACD. You can see how the MACD signals confirm those provided by Momentum. (Please note that MACD and Momentum are both based on calculations involving price and time - so they offer slightly different views of what is basically the same data - this is not as useful as using a complimentary indicator such as On Balance Volume (OBV) or Price Volume Trend (PVT) which also incorporate volume data.)

We can see that, in comparison to the Computer Software Index, the Financial Index looks much healthier. It is in a definite uptrend, as confirmed by both Momentum and the MACD indicators. The price has recently broken up through the long-term resistance level at 1,740 - which, combined with all the other indications, is a very bullish signal. As an overall sector, financials appear poised to makes some further gains over the coming months.

I recommend that you consider the various sector indices before investing a sizeable amount in any one stock. When you have so many sectors to choose from, why not go with a sector showing a healthy uptrend along with healthy momentum? This type of analysis will also give you valuable insights when considering index or sector funds.

TIPS & TECHNIQUES - Using Momentum

Momentum measures the speed of price change.

• The Momentum line leads price action frequently enough to signal a potential trend reversal in the market.
• Momentum indicators can warn of dormant strength or weakness in the price well ahead of the turning point.
• At extreme positive values, momentum implies an overbought position; at extreme negative values, an oversold position.

Dendrite International, Inc (DRTE) provides a good example of a stock that would have yielded excellent profits over the past five months, primarily using the Momentum indicator to provide buy and sell signals. Here I've illustrated a very useful trading system based on using Momentum and its Moving Average. Currently DRTE looks like it may be poised for a further upward move in the near future... take a look at the chart to see how I've arrived at this conclusion.

The system I have illustrated here is based on the following signals (marked on the chart with Red arrows for Buy and Green arrows for Sell):

• Buy signal - when Momentum crosses upward through its MA it is offering a buy signal. Before acting on this signal, I like to wait for confirmation when Momentum subsequently crosses upwards through the zero or centre line (if it hasn't already crossed). (See Point A on the chart above.)
• Sell signal - when Momentum crosses down through its MA it is offering a sell signal. Since I'm always keen to lock in profits, I usually act on this signal immediately without waiting for Momentum to fall further through the zero line.

Currently DRTE appears poised to break up through both its MA line and the zero line (see Point B in the chart above). The price pattern (upper chart) is in a long term uptrend and has formed a nice triangle formation. If Momentum breaks upwards and the triangle pattern is broken on the upside you have a series of confirming bullish signals.

This Momentum/MA system has proven reliable to many traders in the past. Don't forget to combine this system with trendlines and trend analysis to ensure that you are trading with the overall trend. Properly applied, it can yield great results!

Putting ChartFilter into Context

ChartFilter is meant to complement your overall trading knowledge and decision-making. This newsletter focuses on applying technical analysis (TA) methods to various markets; but this is not to say that you shouldn't be considering important fundamental criteria, such as EPS or revenue, as well. Think of ChartFilter as your TA assistant; not as your overall trading strategist.