Using Momentum to Spot Good Trades

11/03/2015 7:00 am EST

Focus: STRATEGIES

Looking at momentum indicators like MACD and moving average crosses has proven a reliable means for analyzing today's markets. 

Momentum is most easily defined as the acceleration rate of a stock's price.  ETFs or stocks that are accelerating rapidly often continue that directional trend for some time, thus becoming tradable trends, so momentum can be a valuable trading tool to have in your arsenal.

Momentum can be measured in different ways and over different time periods.

The easiest way to measure momentum is by using moving average crossovers.

The chart below depicts a 50-/200-day moving average crossover, as represented by the red and blue lines on the price chart. This is a combination commonly used to determine market direction.  When the short-term blue line moves above the long-term red line, the stock's momentum is positive, and conversely, when the short-term (blue) line moves below the long-term (red) line, the stock's momentum is negative.

These crossover points are generally considered to be buy or sell points when the short-term line moves above or below the long-term line.

chart
Click to Enlarge

In the chart above, the Dow Jones Industrial's short-term blue moving average has moved above the long-term red line to indicate a buy signal, and so the intermediate momentum can be clearly defined as being up.

You can use any length of time you want to plot moving averages ranging from minutes to years, but one must be consistent and understand what the moving averages are telling.

Momentum is only valid as a trading tool if your time horizon and trading style match the momentum indicator you're using.

Therefore, if you're using short-term momentum, your indicator would only be valid for short-term price changes, and so your trading horizon should be short as well. Conversely, if you're using longer-term momentum indicators—say monthly—changes in momentum would indicate price movement for periods of one to several months.

A second way to measure momentum is to use a widely followed indicator, like MACD, which is shorthand for Moving Average Convergence/Divergence, an intimidating phrase that describes the combination of a trend following and momentum indicator.

In other words, MACD is both a trend indicator and a momentum indicator, so by studying it, one can determine if a security is in an uptrend and if its momentum, or price velocity, is accelerating or declining.

In this example of DJIA, MACD on the bottom of the graph is climbing and above the "0" line, so prices and momentum are in a clearly defined uptrend. Also, the short-term blue line has moved above the long-term red line to indicate an upward trend in prices.

chart
Click to Enlarge

However, in this chart of the DJIA, one can see that MACD momentum is waning, which could be an indicator of an impending change in direction, so it should be closely watched over the next several trading days.

So in today's markets, the combination of moving averages with MACD can still give you a good picture of a stock or ETFs direction, trend, and momentum. This picture can help improve your chances of picking a winner and having a successful investment over the short or long term, which of course, is the goal we all seek.

However, the best news is that these same indicators have the ability to protect us from the correction that one day is sure to come one day when-not if-the Teflon wears out.

By John Nyaradi, publisher, Wall Street Sector Selector

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