Module 12

Momentum Indicators & Oscillators

Oscillators or Indicators

Now we will talk about momentum indicators

The term “momentum” refers to the velocity of a price trend.

This indicator measures whether a rising trend is accelerating ordecelerating or whether prices are declining at a faster or slowerpace.

Intraday Momentum Index - IMI

The Intraday Momentum Index (IMI) was developed by Tushar Chande. It is a cross-breed between the RSI and CandlestickAnalysis

The calculation of the IMI uses the relationship between the intraday opening and closing prices to determine whether the day is "up" or "down." If the close is above the open, it is an up day. If the close is below the open it is a down day. Therein lies its tie to candlestick charting. For those familiar with Candlestick charting, the IMI separates the black and white candlesticks and performsan RSI calculation on the Candlestick bodies.

Relative Strength Index - RSI

The Relative Strength Index (RSI) is a popular oscillator used by traders. It was first introduced by J. Welles Wilder in an article in ‘Commodities’ (now known as ‘Futures’) magazine in June, 1978. Step-by-step instructions on calculating and interpreting the RSI are also provided in Mr. Wilder's book, ‘New Concepts in Technical Trading Systems ‘.

The name "Relative Strength Index" is slightly misleading as the RSI does not compare the relative strength of two securities, but the internal strength of a single security. A more appropriate name might be "Internal Strength Index."

Relative Strength Index - RSI

The RSI is a fairly simple formula, but is difficult to explain without pages of examples. The basic formula is:

U = an average of upward price changes.D = an average of downward price changes.

DU

1

100100RSI

50%

100%

0%

elativetrengthndex

Moving Average of RSI (half to two thirds the period of RSI)

1001+ U/D

100 -

U=150 D=200

D=120

Relative Strength Index - RSI

Rate of Change - ROC

The Price Rate-Of-Change (R.O.C.) indicator (percent method) is calculated by dividing the price change over the last x-periods by the closing price of the security x-periods ago. The result is thepercentage that the security's price has changed in the last x-periods

If the security's price is higher today than x-periods ago, the R.O.C. will be a positive number. If the security's price is lowertoday than x-periods ago, the R.O.C. will be a negative number.

Rate of Change - ROC

C – LLV * 100

HHV – LLV

50%15

20HHV

10LLV

90%

100%

75%17.5

100%

100%

90%

75%

50%

To improve it we calculate a 3 period MA of these percentages we get :

96.7%

%K %D75%

91.6%

Stochastic Oscillator

The Stochastic Oscillator Technical Indicator compares where a security’s price closed relative to its price range over a given time period. The Stochastic Oscillator is displayed as two lines. The main line is called %K. The second line, called %D, is a Moving Average of %K. The %K line is usually displayed as a solid line and the %D line is usually displayed as a dotted line.

Stochastic Oscillator

%K = (CLOSE-LOW(%K))/(HIGH(%K)-LOW(%K))*100

Where:CLOSE — is today’s closing price;LOW(%K) — is the lowest low in %K periods;HIGH(%K) — is the highest high in %K periods.

%D = SMA(%K, N)

Where:N — is the smoothing periodSMA — is the Simple Moving Average

Stochastic Oscillator Formula

Oscillator(Indicator)

Analysis

Analyze in three – Dimensions

TREND - Bullish or Bearish

AREA - Overbought or Oversold

DIVERGENCES - Bullish or Bearish

OscillatorDirection

Direction – Up & Down

Momentum, like prices, move in trends.

This means that the techniques used for analysing price trends like using moving averages can be used for appraising momentum trends.

We must keep in mind that a trend reversal in momentum is not always associated with a similar reversal in the price.

PRICE IS THE BOSS.

OscillatorExtremes

Area – Overbought & Oversold

Markets are essentially driven by psychological forces.

Our emotions move from one extreme to another, from greed to fear, from hope to despair.

This is what causes momentum indicators to fluctuate from overbought to oversold levels.

In a sense, momentum reflects crowd psychology and measures the intensity of the emotions of market participants

ConvictionEnthusiasm

ConfidenceGrowing recognition

HopeDisbelief

Contempt SurrenderDisgust

CautionSkepticism Apprehension

Shock & fear

Gre

ed

Psychology – Investor behavior

Contrarian Theory

A trading theory that recommends making investments contrary to the apparent direction of the market or commonly accepted wisdom. The theory holds that if everyone is certain something is going to happen, then it won't.

Contrarians also draw their conviction from the viewpoint that if everyone believes the market will rise, they have already bought.Thus, there are few investors remaining to create additional buying, which means it is likely that the market will decline. Some mutual funds have adopted a contrarian trading strategy as their main focus.

So when your grandmother wants to buy…

Area – Overbought & Oversold

All momentum oscillators move from one extreme to another.

Some oscillators, like RSI and IMI are calculated in such a way that they fluctuate between 0% and 100%. In these cases there is an established level for the Overbought and Oversold lines in the above cases 70% and 30%

Other oscillators, Like ROC or Momentum do not have maximum or minimum levels so in this case we must calculate the Overbought and Oversold lines ourselves.

OscillatorDivergences

Divergences– Bullish & Bearish

In a nutshell, divergence can be seen by comparing price action and the movement of an indicator. It doesn't really matter what indicator you use. You can use RSI, MACD, ROC, IMI, etc. Just think "higher highs" and "lower lows".

If price is making higher highs, the oscillator should also be makinhigher highs. If price is making lower lows, the oscillator should also be making lower lows.

If they are NOT, that means price and the oscillator are divergingfrom each other And that's why it's called "divergence.“

divergence is used as a possible sign for a trend reversal

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Bullish Divergence

Divergences– Bullish

If price is making lower lows (LL), but the oscillator is making higher lows (HL), this is considered to be positive ( bullish) divergence.

This normally occurs at the end of a down trend. After establishing a second bottom, if the oscillator fails to make a new low, it is likely that the price will rise, as price and momentum are normally expected to move in line with each other.

A divergence is used as a possible sign for a trend reversal

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Bearish Divergence

Divergences– Bearish

If the price is making a higher high (HH), but the oscillator is lower high (LH), then you have negative (bearish) divergence.

This type of divergence can be found in an uptrend After price makes that second high, if the oscillator makes a lower high, then you can probably expect price to reverse and drop.

A divergence is used as a possible sign for a trend reversal

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Divergences– Bullish & Bearish

As you can see from the images above, the divergence is best used when trying to pick tops and bottoms. You are looking for an area where price will stop and reverse.

The oscillators signal to us that momentum is starting to shift and even though price has made a higher high (or lower low), chances are that it won't be sustained.

A divergence is used as a possible sign for a trend reversal