We are all creatures of nature. We like to be accepted and appreciated and like to fit in. Since the market is made up of market participants it is important to be able to measure this phenomenon, and attempt to take advantage of it when it occurs. Granted, most of the time, the really big money is made by buying when the crowd is selling and selling when the crowd is buying, catching the diving knife can be a painful exercise. Many believe that waiting until the momentum picks up is better suited for their trading personality.
A trading personality is how you conduct yourself in life when it comes to purchase and sales. If you scour over the internet looking for the best sale and you are willing to forego other opportunities to get the price you want, then catching the falling knife and buying as a market plunges might be right for you. If instead, you are a buyer and not a shopper, and when you see what you want you grab it, then trading with momentum is a strategy that might work for you.
Momentum is when price action accelerates in one direction and picks up steam as prices continue to trend. If can be view as the rate as which change occurs, and an acceleration of that rate of change. Monitoring the rate of change as the market moves is a prudent endeavor and can help you find situations that are in line with your trading style.
Over the years, there have been many technical indicators introduced that evaluate momentum. Most focus on measuring the percent change in price from one period to the next. The general premise is that you are comparing the current price with the price “x” periods ago. With this information you can generate an oscillator which is an index that fluctuates from 1-100. An oscillator that fluctuates in this manner, such as the relative strength index, may be used to generate buy and sell signals as the index moves above or below specific levels. You may also use this type of oscillator to find extremes when the market is either overbought or oversold.
Another way to measure momentum which somewhat smooths the period you are evaluating and eliminates some of the noise markets generally produce is to analyze the changes in different moving averages. This is exactly what is accomplished with the Moving Average Convergence Divergence index.
The MACD was introduced by Gerald Appel, and is one of the most efficient ways to measure momentum. The indicator accomplishes this process by subtracting a long term moving average from a short term moving average, and creating a spread. The spread is then compared to the 9-day moving average of the spread, which provides an index.
The MACD is used in multiple ways and there is nothing that says a trader cannot alter the lengths to find strategies that produce signals where momentum is focused on a shorter term horizon or longer term horizon.
The most common way to use the MACD is to find buy and sell signals that are predicated on changes in momentum. They are made relatively easy by looking for and using crossovers. In the chart above of the S&P 500 index you can see a positive momentum crossover when the spread crosses above the 9-day moving average of the spread in late January. The signal was confirmed as the index which is identified by the histogram, moved from negative to positive territory. In mid-February you can see that there was a sell signal created as the spread crossed below the 9-day moving average of the spread. Here the index moved from positive to negative territory confirming the sell signal.
The divergence terminology of the MACD is similar to an oscillator that shows overbought or oversold levels. Reading a divergence is relatively subjective but the underlying theme is that when the index moves in one direction and prices move in another you have a divergence.
In closing, the concepts surrounding momentum is finding acceleration in price action that is similar to the way you would trade the markets if it fits into your trading personality. Those who are looking to catch the trend may be best suited to find momentum indicators and aim to profit from the accelerating price action.