Momentum indicators are leading indicators. This means that they can indicate the direction of the market before this manifests in the price. For this reason, they can be used in trending markets to predict a price move before it actually happens.
There are two types of trending markets.
An uptrend is formed by higher highs and higher lows. A downtrend is formed when the price forms lower highs and lower lows. For this discussion,we’ll treat the sideways markets (range-bound or consolidating markets) separately.
So how can you squeeze momentum indicator profits in trending markets? There are two ways to do this.
- Reversal of a trend using the divergence signal
- Detection of reversal points at price extreme areas.
Here are the possible oscillator trade setups.
1. Divergence signals
Divergence is a situation where a line that connects the most recent peaks of the signal line of the momentum indicator faces downwards, while a similar line which connects the price peaks faces upwards. In this case, the momentum indicator is leading the price, which is expected to correct itself to the downside. This is a bearish divergence setup.
Also, a divergence exists when a line which connects the two most recent troughs of the signal line of the oscillator points upwards, while a similar line which connects the most recent troughs of price faces downwards. Again, price is expected to correct the divergence by moving higher so that its troughs can align with those of the indicator.
Experience has shown that this is one of the best momentum indicator signals you can ever use on any time frame. However, a trader still needs an entry signal (usually a candlestick signal) to enter into the trade based on the divergence signal.
This is an example of how price corrected a bearish divergence on the weekly chart of BoA. Here, the perfect stock momentum indicator used was the commodity channel index (CCI). You can also use the momentum indicator and the DeMarker oscillator. These three are the best momentum indicators when it comes to divergence signal trading.
The entry signal was the hammer and the bearish candle follow-up. A short trade is used. In exiting a sell trade from a bearish divergence, it is a good idea to use previous support, or a resistance-turned-support (as shown above) level as a guide.
You can use similar setups (but in reverse) to detect a bullish divergence scenario.
From the sell trade example provided previously, can you spot the divergence and entry/exit areas on the snapshot above?
2. Price Extreme Signal
In trending markets, price extremes (overbought/oversold market conditions) can be used to detect price reversal points. However, many traders get this signal all wrong. Even the best momentum indicator signals using price extremes must be interpreted correctly otherwise the entire trade setup would go to pieces.
One thing every trader must know is that the signal line of a momentum indicator can stay in a price extreme area for a long time, and while this is going on, the price may continue to trade higher in an uptrend or lower in a downtrend. Setting a reversal trade prematurely in these circumstances would fail.
Rather, the trader should deploy what is known as a ‘failure swing’ setup. This is a setup in an uptrend, where two successively lower peaks are formed by the indicator’s signal line in the overbought extreme area. Also, this setup forms where two successively higher troughs form in the oversold area. The best momentum indicator for this is the relative strength index (RSI).
Here is how to detect and use this setup to squeeze momentum indicator reversals in trending markets.
You will notice one thing on the indicator window: the signal line stayed in the overbought area for some time. Right before the ‘failure swing’, the indicator spent close to three weeks in the overbought area.
However, two successively lower peaks formed, indicating a failure of the bulls to sustain further uptrend. This signal of price exhaustion eventually played out on the charts as a downward reversal.
A similar setup also occurs in the oversold area. However, the failure swing in the overbought region tends to produce stronger price reversals.
The one shown on this chart produced a $3.51 price move, which could potentially have delivered $351 with a purchase of 100 shares. A live account on an MT4 broker provides access to stock trading where you can replicate these moves using the right strategy.