Three Times the Speed

Three Times the Speed

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).

S&P500 weekly momentum divergences in the sustainable bull trend zone - don't expect a trend changeIn 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.

S&P500 chart detail with typical bullish slingshotThe 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).

Illustration: Coordinating the weekly and the monthly time frames at the 1998 October lowSince 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?

Recap

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.

About Laszlo Nagyferenczi

Laszlo Nagyferenczi is a day trader, analyst and instructor as well as the creator of the proprietary Context-Momentum-Signal concept. He has authored over 200 blog articles about his unique approach to trading and the Elliott Wave Theory. His clients appreciate his ability to go from the theoretical to the practical i.e. all the way to the actual trade set ups. Originally hailing from Hungary, Laszlo is fluent in English and Hungarian with a long list of education credentials including BA in Economics, Certified Elliott Wave Analyst (CEWA), Certified Adult Educator for T-Groups, Professional Co-Active Coach (PCC) at CTI. The real education, though, has been the trial by fire in the markets, with real capital at risk.

2 comments:

  1. Hi László!

    Please check my uploaded picture of the current EURUSD situation. If I understand correctly, there are 2 convergences between price and RSI. (1-2 and i-ii) and a 1st RSI top above the sustainable bull momentum area (3).

    My questions:
    – 1st top above 83 means it’s a 3rd of 3rd, or it’s too high and it’s better call C, not a 3? The 1st RSI can be above 83 or it’s not normal?
    – It seems after the correction the price is turning, but RSI is under 50 (~40). Is it ok, or this also point that it’s more than correction?
    – About time frames. I use 1hr chart to entry a trade. What is your opinion. Is it enough to check 4hr chart as a larger tf, or check daily is helpful too? Because sometimes I have position for 2 weeks,which means 10 daily bar.

    I just find your web page now and I’m reading all of the articles.

    Thanks sharing your experiences!
    Waiting your answer,
    Géza

  2. Hi Geza,

    Thanks for the question. For the Elliott wave interpretation and some momentum comments please read my latest as I had a little different idea about the convergence: http://traderskillset.com/eurusd-fomc-turbulence/

    It is not necessary to interpret a series of convergences, it is enough if you compare the lows at your 2 and ii labels. It is above the sustainable bear trend zone therefore good enough for another rally.

    On the other hand the hourly bull was not the ideal time frame choice for a swing trade as that is what your labeling would suggest. It was just a scalp type trade lasting a few bars (few hours) because did not have larger time-frame coordination with the weekly and the daily. Both of them were beaten up deep in the sustainable bear zone. If you hold your positions for days and weeks you definitely have to use my RSI guidelines on the daily and the weekly. Like I previously said it was bull only on the hourly and the hourly bull does not have enough overnight chance against the daily and weekly bears.

    Wave ones might poke into the sustainable bull territory but it is rare. If you see something like that especially when the penetration is deep, you have to check the one larger time-frame because probably there is a higher degree trend in force that is more dominant.

    The ultimate RSI support on a time frame in bull or range situations is the 38-40 level. Check out: http://traderskillset.com/glossary/bull-market/

    I hope it helps to answer at least a good chunk of your questions.

    Cheers,
    Laszlo

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