CHAPTER 5

FIN555
Introduction to Technical Analysis

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 MOMENTUM I:
BASIC PRINCIPLES (ROC)
5.0 Introduction
5.1 Selection of Time Span
5.2 Principles and Application of Momentum Indicators
5.3 Momentum Characteristics
5.4 Momentum Trend Reversal Techniques

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 5.0
INTRODUCTION
Let’s start our first set of slides

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 Introduction

The methods of trend These techniques are extremely useful,

determination considered so far but they identify a change in trend only
have been concerned with after it has taken place. The use of
analysis of the movement of the momentum indicators can warn of latent
price itself through trend lines, strengths or weaknesses in the indicator
price patterns, and moving- or price being monitored, often well
average (MA) analysis. ahead of the final turning point.

Major Technical The use of momentum indicators can warn of latent strengths
Principle or weaknesses in the indicator or price being monitored, often
well ahead of the final turning point.

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 Introduction

Momentum is a generic term. Just as Examples include rate of change (ROC), the
“fruit” describes apples, oranges, relative strength indicator (RSI), moving-
grapes, etc…, so “momentum” average convergence divergence (MACD),
embraces many different indicators. breadth oscillators, and diffusion indexes.

Major Technical The principles or characteristics of momentum interpretation

Principle are the same for all indicators, but some are specially
constructed to bring out a particular characteristic.

Major Technical It is of paramount importance to use momentum analysis in

Principle conjunction with some kind of trend-reversal signal in the price
series itself.

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 Momentum Interpretation

RATE OF CHANGE (ROC)

The simplest way of measuring In short, a rising ROC indicator implies

momentum is to calculate the rate at expanding velocity, and a falling one
which a security price changes over a implies a loss of momentum. Rising
given period of time. This is known as a momentum should be interpreted as a
rate of change (ROC) indicator. bullish factor, and declining momentum as
a bearish one.

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 Momentum Interpretation

RATE OF CHANGE (ROC)

If it is desired, for example, to construct

an ROC using a 10-week time span, the
current price is divided by the price 10
weeks ago. If the latest price is 100 and
that one 10 weeks ago was 105, the ROC
or momentum indicator will read 95.2, that
is, 100 divided by 105. The subsequent
reading in the indicator will be calculated
by dividing next week’s price by the price
9 weeks ago (see Table 13.1); the result
is a series that oscillates around a central
reference point.

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 5.1
SELECTION OF TIME SPAN
Let’s start our second set of slides

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 Selection of Time Span

Choosing the correct time span For intermediate trends, a 9-month, 26-week
is important. For longer-term (6-month), or 13-week (3-month) momentum
trends, a 12-month or 52- week works well. Price movements of even shorter
momentum is generally the most duration are often reflected by a 10-, 20-, 25-,
reliable, although a 24- or 18- or 30-day span. Reliable short/intermediate
month period can also prove movements are often reflected with a 45-day
useful. (9-week) span.

Major Technical The analysis of any technical situation will be enhanced by the
Principle calculation of several momentum indicators, each based on a
different time span.

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 5.2
PRINCIPLES AND APPLICATION OF MOMENTUM
INDICATORS
Let’s start our third set of slides

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 Principles and Applications of Momentum Indicators

These principles can be roughly divided into two broad categories:

Those that deal with overbought conditions, oversold

The identification of trend
conditions, divergences, and the like. It is call
reversals in the momentum
momentum characteristics. If you study momentum
indicator itself. I will call these
indicators or oscillators, you’ll find that they have certain
momentum trend reversal
characteristics that are associated with subsurface
techniques. In this case, we are
strengths or weaknesses in the underlying price trend.
making the assumption that
when a trend in momentum is
It’s rather like looking under the hood of an engine. reversed, prices will sooner or
Quite a lot of the time you can identify mechanical later follow.
trouble before it becomes self-evident.

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 5.3
MOMENTUM CHARACTERISTICS
Let’s start our fourth set of slides

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 Momentum Characteristics

1. Overbought and Oversold Levels

Perhaps the most widely used method of

momentum interpretation is the
evaluation of overbought and oversold
levels. This concept can be compared to
a person taking an unruly dog for a walk
on a leash. The leash is continually being
pulled from one side of the person to the
other as the dog struggles to get free.
Despite all its activity, however, the dog
can move no farther away than the
length of the leash.

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 Momentum Characteristics

1. Overbought and Oversold Levels

The same principle holds true for

momentum indicators in the marketplace,
except that the market’s “leash” should
be thought of as made of rubber, so that
it is possible for particularly strong or
weak price trends to extend beyond the
normal limits, known as overbought and
oversold levels. These areas are drawn
on a chart at some distance above and
below the equilibrium level, as in Figure
13.3.

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 Momentum Characteristics

2. Oscillator Characteristics in
Primary Bull and Bear Markets

In a bull market, oscillators tend to move

into an overbought condition very quickly
and stay there for a long time.

In a bear market, they can and do remain

in an oversold condition for a long time.
In effect, an oscillator is not unlike a
migrating bird in the Northern
Hemisphere. The price action in Figure
13.4 into a bear market, followed by a
bull, and finally another bear market.

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 Momentum Characteristics

3. Overbought / Oversold Re-crossovers

In most cases, excellent buy and sell

alerts are generated when the
momentum indicator exceeds its
extended overbought or oversold
boundary and then re-crosses back
through the boundary on its way to zero.

Figure 13.5 demonstrates this possibility.

This approach filters out a lot of
premature buy and sell signals generated
as the indicator just reaches its
overextended boundary, but one should
still wait for a trend reversal in the price
itself before taking action.
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 Momentum Characteristics

4. Mega Overboughts and Oversolds

There is a close connection between

market sentiment indicators and the
characteristics of oscillators. Since
market sentiment differs widely during a
bull and bear market, it follows that such
variations are occasionally reflected in
changing characteristics of momentum
indicators.

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 Momentum Characteristics

4. Mega Overboughts and Oversolds

It takes a tremendous amount of energy

to achieve, but once the door is finally
shoved open, there is nothing to hold that
person back any longer. In the same
way, a mega overbought removes the
price from its bear market constraints,
leaving it free to experience a new bull
market. An example is shown in Figure
13.6.

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 Momentum Characteristics

5. Extreme Swings

The extreme swing is another

phenomenon that signals a dramatic shift
in psychology. It reflects the idea that
some primary trend reversals are
signaled by a swing from unbelievable
exuberance as the bull market reaches
its peak, to one of complete
despondency and depression as the first
bear market setback gets underway.

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 Momentum Characteristics

5. Extreme Swings

The opposite is true of a transition from a

primary bear to a primary bull market. In
order for an extreme swing to develop, it
is necessary to experience a prolonged
uptrend or downtrend. The extreme
swing then appears in a momentum
indicator by an especially strong move in
the direction of the then-prevailing trend,
as shown in Figure 13.8.

Major Technical Mega and extreme conditions represent preliminary signals of a

Principle primary trend reversal. Confirmation by the price usually puts
the issue beyond reasonable doubt.
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 Momentum Characteristics

6. Divergences

The ball example used at the beginning

of the chapter showed that maximum
velocity was obtained fairly close to the
point at which the ball leaves the hand.
Similarly, prices in financial markets
usually reach their maximum level of
momentum ahead of the final peak in
prices. In Figure 13.10, this is shown at
point A.

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 Momentum Characteristics

6. Divergences

If the price makes a new high, which is

confirmed by the momentum index, no
indication of technical weakness arises.
On the other hand, if momentum fails to
confirm (point B), a negative divergence
is set up between the two series, and a
warning of a weakening technical
structure is given.

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 Momentum Characteristics

6. Divergences

However, the price will sometimes

continue upward to a third top and be
accompanied by even greater weakness
in the momentum index (point C).

Figure 13.10 also shows a positive

divergence. In this instance, the price
makes its low at point E, but this was
preceded by the oscillator, which
bottomed at D

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 Momentum Characteristics

6. Divergences

It is extremely important to note that divergences only warn of a

Major Technical
weakening or strengthening market condition and do not
Principle
represent actual buy and sell signals.

Major Technical As a general rule, the greater the number of negative

Principle divergences, the weaker the underlying structure.

Major Technical A divergence that develops close to the equilibrium line is often
Principle followed by a sharp price move when confirmed by the price.

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 Momentum Characteristics

7. Price Discrepancy Divergence

A further indication of subtle strength or

weakness is given when the momentum
series moves strongly in one direction,
but the accompanying move in the price
index is a much smaller one.

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 Momentum Characteristics

7. Price Discrepancy Divergence

Such a development suggests that the

price index is tired of moving in the
direction of the prevailing trend, for
despite a strong push of energy from the
momentum index, prices are unable to
respond. This unusual, but powerful,
phenomenon is illustrated for both tops
and bottoms in Figures 13.13 and 13.14

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 Momentum Characteristics

8. Complex Divergences

It is widely recognized that price

movements are simultaneously
influenced by several cyclic phenomena.
Because a single momentum indicator
can monitor only one of these cycles, it is
always a good idea to compare several
different momentum indicators based on
differing time spans.

One approach is to plot two momentum

indicators of differing time spans on the
same chart, as shown in Figure 13.15.

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 5.4
MOMENTUM TREND REVERSAL TECHNIQUES
Let’s start our fifth set of slides

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 Momentum: Individual Indicators

Rate of change (ROC) measures the speed The use of an ROC indicator helps to
of an advance or decline over a specific time explain some of the cyclical movements
span and is calculated by dividing the price in in markets, often giving advance warning
the current period by the price N periods ago. of a reversal in the prevailing trend, but a
The longer the time span under specific time frame used in an ROC
consideration, the greater the significance of calculation reflects only one cycle. If that
the trend being measured. Movements in a particular cycle is not operating, is
10-day ROC are far less meaningful than dominated by another one, or is
those calculated over a 12- or 24-month time influenced by a combination of cycles, it
span and so forth. will be of little value.

At any one time, price is determined by the interaction of many

Major Technical
different time cycles. An indicator that takes this into consideration is
Principle
likely to be timelier without losing too much in the way of sensitivity.

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Momentum: Individual Indicators

This point is illustrated in Chart 15.1,

which shows three ROC indicators of
different time spans: 9 months, 12
months, and 24 months. The 9-month
ROC tends to reflect all of the
intermediate moves, and the 24-month
series sets the scene for the major
swings. The arrows flag the important
turning points in this period. They show
that, for the most part, all three ROCs are
moving in the same direction once the
new trend gets under way.

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Momentum: Individual Indicators

One ROC time span taken on its own

does not give us a complete picture. This
was one of the factors considered in the
design phase of the KST. Another
requirement was an indicator that fairly
closely reflected the major price swings
over the time period under consideration,
primary trends for monthly charts, short-
term trends for daily charts, and so forth.

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 Momentum: Individual Indicators

Chart 15.3 compares the performance of

the smoothed 24-month ROC to the long-
term KST between 1974 and 1990. It is
fairly self-evident that the KST reflects all
of the major swings being experienced
by the smoothed 24-month ROC.
However, the KST turning points develop
sooner than those of the ROC. The
vertical arrows slice through the ROC as
it bottoms out. In every instance, the KST
turns ahead of the arrow, the lead time
varying with each particular cycle.

Major Technical Principle The KST should always be used in conjunction with other indicators.

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 Short And Intermediate-term KSTs

The KST concept was originally derived

for long-term trends, but the idea of four
smoothed and summed ROCs can just
as easily be applied to short-term,
intermediate, and even intraday price
swings. Formulas for various time frames
are presented in Table 15.2.

Major Technical Sometimes, a study of the characteristics of an oscillator can be helpful in

Principle identifying the direction of the primary trend. Weak rallies indicate bear
markets, and weak reactions indicate primary uptrends.

Major Technical The first rule in using the short-term KST is to try to get a fix on the direction
Principle and maturity of the primary trend and never trade against it.

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Short And Intermediate-term KSTs

Identifying the direction of the main trend

is easier said than done. However, if you
pay attention to the price relative to its 65-
week or 12-month MA and the level and
direction of the long-term KST, or Special
K (explained later in this chapter), you will
at least have an objective measure of the
primary trend environment.

Chart 15.10, featuring Indian Hotels,

again brings out the concept of
constructing overbought and oversold
lines and seeing what happens when the
KST reverses from such levels.

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 Using The KST In The Market Cycle Model

Three Main Trends Earlier chapters explained that there are several
trends operating in the market at any particular time. They range from
intraday, hourly trends right through to very long-term or secular trends
that evolve over a 19- or 30-year period. For investment purposes, the
most widely recognized trends are short-term, intermediate- term, and
long-term. Short-term trends are usually monitored with daily prices,
intermediate-term with weekly prices, and long-term with monthly prices.

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Combining The Three Trends

Ideally, it would be very helpful to

track the KST for monthly, weekly,
and daily data on the same chart,
but plotting constraints do not easily
permit this. It is possible, though, to
simulate these three trends by using
different time spans based on
weekly data, shown for the S&P
European 350 ETF in Chart 15.11

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THANKS!
Any questions?

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