By: Spencer Israel
“The trend is your friend.”
“Don’t fight the tape.”
These aren’t just old Wall Street clichés. They’re also overly simplified descriptions of one of the most tried-and-true trading strategies: momentum trading.
Simply put, momentum trading is based on the fundamental idea that money can be made going long stocks (or futures, ETFs, or any other type of security) that are already on their way up, and shorting stocks (or futures, ETFs, etc) already on their way down.
In other words, focusing on stocks that already have momentum.
The rub, however, lies in determining how likely a stock’s momentum in price is going to continue and, more importantly, when it might end. Are there other indicators that suggest it will? Is it related to any fundamental catalyst? What are related stocks doing? These are but a few of the relevant questions that can potentially factor into the equation.
Fortunately, there are a few technical tools we can use to help us determine how strong or weak a stock’s momentum is. Technical analysis indicators are generally broken down into a few categories based on what they help quantify: momentum, trend, and volatility.
Here are three of the most popular technical indicators that you can use to quantify momentum:
Moving Average Convergence Divergence (MACD)
Moving Average Convergence Divergence is exactly what it sounds like—it compares the movements between two different moving averages. Typically, MACD is calculated by subtracting the 26-day exponential moving average from the 12-day moving average (though those date ranges can change.
The result of that calculation is plotted on a chart as the MACD line. That’s part one of the MACD indicator. The other part is a nine-day exponential moving average taken of the MACD line, which is also plotted on a chart.
How those two lines move in concert with each other determines whether a trend may be strengthening or weakening. When the two lines cross, that indicates that a trend may be accelerating. When they diverge, that’s considered a signal that the trend is weakening.
Relative Strength Index (RSI)
Not to be confused with Relative Strength, the Relative Strength Index, or RSI, measures the speed and magnitude of price movements. It does this by comparing a stock’s recent moves to its average moves over the previous 14 trading days.
RSI operates on a scale from 0-100, and on your chart, it will take the shape of a continuous line that moves along that scale.
There are two general rules of thumb for using RSI:
- When RSI is above 70, it’s considered “overbought,” meaning you may want to consider selling
- When RSI is below 30, it’s considered “oversold,” meaning you should consider buying
The main thing to pay attention to with RSI is how it moves along that scale and watching to see if it crosses over into overbought or oversold territory.
The stochastic oscillator compares a stock’s closing price to a range of previous closing prices. Stochastics are based on a complex formula but are very similar to RSI in how they look and are interpreted.
Just like RSI, the stochastic oscillator is measured on a scale of 0-100. When the stochastic line moves above 80, that is considered an overbought signal. Below 20 is considered an oversold signal.
How the stochastic oscillator moves in relation to price can tell us if a stock’s momentum in one direction may soon accelerate or change entirely. If a stock is moving in a down trendline while the stochastic oscillator is moving in an upward trend line, that’s a bullish signal the downtrend could soon change to an uptrend. If a stock is moving in an upward trendline while the stochastic oscillator is moving in a downward trend, that’s a bearish signal that indicates the stock may soon go lower.
Momentum trading is a widely used strategy, but it’s not meant for everyone. You need to have the ability to pay close attention to sudden price moves and execute trades quickly without second-guessing yourself. There is no such thing as a foolproof strategy or a guaranteed way to know when a trend is going to change, but the indicators above will help.
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