One theme that opportunistic traders like to follow is the momentum strategy. Here they like to take advantage of a short and sharp rise in the market.
Momentum strategies, as the name suggests, is getting in stocks when they are picking up speed either in the upward or downward direction.
Just like a driver looks at the speedometer to gauge the speed of his vehicle a trader looks at certain indicators to judge the speed of the underlying stock or indices. These indicators are clubbed under the category of Momentum Indicators.
There are various types of momentum indicators that are constructed using different styles.
Some indicators are constructed using a single reference point and measuring the speed of the market from that reference point, like the Rate of Change (ROC) indicator, Relative Strength Index (RSI), and Stochastics.
Others like Moving Average Convergence Divergence (MACD) and Average Directional Index (ADX) that are constructed using the directional movement of the market.
One can use any of the indicators based on their backtest and comfort. Apart from selecting the indicator, a trader can tweak the parameters to suit his comfort zone.
We shall now look at some of the popular momentum indicators.
1)Relative Strength Index RSI
This is one of the most popular momentum indicators, which is also at times used as a trend indicator. A stock or index with an RSI value of above 50 is considered to be in a bullish trend and a value of below 50 is bearish.
RSI, being an oscillator moves between 0 and 100, and a value of above 70 is considered overbought and that of below 30 is oversold.
However, momentum traders use a value of above 60 to pick momentum trades and a value of below 40 to short sell.
The chart shows how the rise and fall picks up speed after crossing the 60 and 40 points.
Note that the RSI indicator gave a signal before the support-resistance line drawn in the chart above.
There are various ways in which traders use the RSI indicators. Some of the other popular ways of using the indicator is a divergence between indicator and price.
Another popular momentum indicator is Stochastic. Though it has an uncanny ability to pick the top and the bottom, the main drawback of the indicator is the number of false signals generated by it.
Just like RSI, Stochastic is also an oscillator and hence bound within boundaries. Here too, the general perception is that when the oscillator crosses 80 it is in an overbought zone and a value below 20 is oversold.
However, momentum traders use these levels to take a position when the stochastic enters the overbought and oversold zones.
Exits from the overbought and oversold zone are considered as entry points for taking a position in line with the trend as shown in the chart below.
3) Moving Average Convergence Divergence (MACD)
A popular momentum indicator is the MACD which uses moving averages for its construction. It generally uses the relationship between a 26-period exponential moving average (EMA) and a 12 EMA.
When the two moving averages diverge it is considered that the stock is picking up momentum while when it converges, it suggests that the momentum is coming to an end.
The indicators consist of the MACD line and the signal line. The MACD line tracks the difference between the two EMA while the signal line is the 9 EMA of the MACD line.
Traders use the crossover of these lines to take entry signals.
There are many ways in which traders use the MACD for taking trades. Like some traders prefer taking long trades only when the crossover is above the zero line and short trade when the crossover is below the zero line. Divergences between prices and MACD are also used to pick up trades.
Like most indicators, it is up to the creativity of the trader to make use of the indicator to trade profitably. One thing to remember is that no indicator will work all the time in the market.
There is bound to be whipsaws in trading. Finally, trading is a mental game, indicators will keep on giving you buy and sell signals, it is the perseverance of the trader that will ultimately result in his being successful.
(The author is Chairman, TradeSmart)
(Disclaimer: Recommendations, suggestions, views, and opinions given by the experts are their own. These do not represent the views of Economic Times)