Many traders have a basic understanding of momentum. But, we think most traders would benefit from three tweaks to the traditional thoughts on the topic.
In fact, in our proprietary trading system, momentum helps to identify and confirm the context; and, as such, it is the link between historical prices and the short term signals.
Traditional Momentum Indicators
Momentum in technical analysis refers to the speed of price changes. By taking a closer look at classic indicator formulas like ROC, RSI or Stochastics, we can easily understand that they all measure an instrument’s price change over a given time span:
- Rate of Change or ROC measures the change between the most recent price and the price “N” bars ago (usually 10 bars).
- Welles Wilder’s Relative Strength Index, or RSI, compares the average price change of the up closing bars to the average price change of the down closing bars of the last 14 bars (default setting).
- Stochastics show current closing price position in the context of the recent “N” periods’ price range.
Learning the definitions, in order to repeat them out loud, will not make you a better trader. Instead, think of momentum, or speed, like this: a mathematical calculation applied to price. It’s as simple as that.
How Trader Skillset uses Momentum
We use momentum, “speed,” or velocity information for three reasons.
1. CONFIRMATION OF THE CONTEXT
As we previously discussed in this article, the definition of context is to spot the market’s current position within the dominant market cycle (or larger timeframe). How do we do this? Every phase within the Elliott cycle has its typical speed characteristics. We have defined the unique momentum character of each and every wave that the Elliott named. In fact, I spent years researching this proprietary set of definitions. I will walk you through the typical momentum behavior in a later article. This time though, I will just continue with the conceptual outline.
The current, or the previous extreme’s, momentum reading is the most useful reference point. For example when the RSI reaches above 67 for the first time, then the price has very likely established what I call the “sustainable bull trend phase.” Once that occurs, I know it is best to consider any bearish price action as a pullback, or correction, within the new dominant bull trend. When the RSI reaches a peak between 67-83, beware of using divergences to call the top, because they’re unlikely produce tradable swing short signals (86% probability against).
In Elliott terms, an initial peak above RSI 67 will likely only signal the middle of the 3rd wave, or a 3rd wave top – meaning that the peak in this dominant trend has not been hit. It will only be hit after seeing divergence in wave 3 of (5), and then finally 5 of (5). So, there may be three or four divergences prior to a lasting top; and, even then, the larger trend is still higher, so the key is that after RSI breaches 67 (blue circles) , any downward price action is likely corrective.
Speaking of high momentum readings, I am not the only guy on the block who sees bullish opportunities after high momentum readings have been struck. George Lane, the inventor of Stochastics, speaks about the “Bernstein interpretation” which he used to trade: “Sometimes the Stochastics goes on up to the top and the market keeps on going. In other words, there’s just so damn much momentum to it that it just keeps on going. Stochastics, when it gets up around 100, can’t do anything so it just bobbles along the ceiling. That kind of thing happens and they are marvelous.” Generally, after an initial push above 67 RSI, we do not try to pick tops – instead, we wait a correction and then trade the bull’s coming appearance.
This behavior likely means a third-of-a-third wave price action or a fifth wave extension, in Elliott’s terms. We have now used momentum indicators to confirm the Elliott Context.
2. DETECTING POSSIBLE CHANGE IN DIRECTION
When we see the momentum oscillator make a lower top while prices are able to reach a new high, it is called a simple divergence. Most of the time a simple divergence means a correction is coming, not a change in trend as the popular technical analysis literature suggests. A simple divergence often appears between waves three and five, and there is usually more than one simple divergence before a more lasting correction (as discussed above). And, a single divergence often leads to a shallow, sideways correction – in fact, it does so more than 50% of the time.
The corrections against an established bull trend often end with a lower bottom on the indicator and a higher low on price. This pattern is called an “oscillator lower-bottom divergence” or “slingshot.” It is a super reliable bullish configuration that signals the continuation of a trend, if you know the optimum parameter ranges. Quite often, it appears between fourth waves of different degrees or waves A and C of running, or failing, corrections.
A simultenaus higher bottom on price and the momentum indicator is the most important but almost forgotten up move convergence. It is very common between the starting point of a new impulse and the wave two bottom, right before the trend accelerates.
To give you a taste of our proprietary “momentum configurations,” we will look at three basic phenomenons, which often form complex variations: multiple divergences, a divergence-convergence combo, or a slingshot-convergence combo. This makes six momentum configurations in a bull trend and six mirroring equivalents in a bear trend. Each identifies the termination of a wave at different significant points of the market cycle. As such, they enable us to both confirm the context and find the end of a corrective or a trending leg. They give us a hint when to search for an entry signal for a trend following position, and when to take profit on a swing trade, because a larger degree correction might be due.
3. COORDINATING AND SELECTING TIME FRAMES
When we identify a promising momentum configuration, we still have another step in the process that confirms a really reliable setup, or diminishes its significance. And, that is the “larger time frame confirmation.” What we like to determine is whether traders, or investors, are prone to share our view about the market’s direction on the next higher time frame. For instance, if we see a 5-minute bullish configuration, then we would like to see the 15-minute timeframe’s momentum indicator also showing sustainable bull trend. The 15-minute traders will sense the pending bullish move and eventually jump on board in same direction, but with a little delay compared to your entry. This gives your 5-minute timeframe trade a boost right when it needs it the most – on the 2nd or 3rd bar following the entry. This works whether we’re looking at 5/15-minute charts, or weekly/monthly charts.
As an example, check our historical example of the “momentum configuration” bullish divergence at the end of a sharp correction in October 1998 (See the featured weekly chart below on the right). Would you have taken the bullish setup shown just after the blue line? When prices made a new low, but RSI remained above 33. After that steep decline? Well, since we have a correct setup, which confirms our context, let’s take a look at the larger time frame (Monthly chart below to the left).
Since the monthly chart formed a final high, prior to the drop in the “sustainable bull momentum area” between our proprietary “magic” level of 67-83; and, it did not cross 50 (i.e. the midpoint on of the indicator pane) the larger timeframe suggested monthly traders would hop on board the bullish weekly set-up, so it was a good long idea. Had the monthly been starting the decline from a lower momentum top of 60-ish, we would have suspected the start of a massive trading range (When one may go long for only a scalp). Nicely coordinated, eh?
We use our traditional momentum indicators, with popular settings – RSI(14) -, but we use them for three purposes in addition to the traditional uses: Confirming the Context, Detecting Change in Direction and Coordinating Time Frames.
Consider finding and squeezing out all of these three interpretations from your existing momentum indicator(s). Try to pick a single oscillator (like RSI) which will allow you to read it fluently and consistently. This will give you an edge, rather than experimenting with different look back periods, trying to invent your proprietary ‘Holy Grail’ formula, or with using half a dozen indicators at the same time.
The time zone we reference on our charts is Pacific Standard Time. Therefore, the U.S. cash market opens at 6:30 AM PST and closes at 1:00 PM PST.