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6.14. Oscillators and Indicators

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6.14. Oscillators and Indicators CMT I. 2015 Topic 6. Chart Pattern and Analysis. 6.14. Oscillators and Indicators. What is Momentum? The word momentum has two meanings to market technicians, one of them is a generic concept about how prices move, and the second one is a specific indicator. So, we are using the expression momentum indicators to refer to the first definition, and momentum indicator for the second one. We are referring to the first concept in this section. As defined by Charles Kirkpatrick “momentum measures how quickly the prices are rising, or how steeply the trendline is sloping”. In other word, momentum is just the rate at which prices are changing, or the second derivative of price movement. From a mathematical point of view, the first derivative of price movement is the slope, and we can measure this with a straightforward trendline. The second derivative refers to how the slope is changing, and that is what momentum measures. Therefore, from a mathematical point of view, momentum refers to the second derivative, or the acceleration/deceleration of price action. Chartism is basically focused on determining the slope of the trend (first derivative), while indicators and oscillators have been designed to measure whether the trend slope is changing or not (second derivative). To detect this change in trend slope, market technicians apply the concept of divergence, according to the following rule: when momentum is confirming the price trend, a “convergence” or “confirmation” occurs; when momentum is failing to confirm the price trend slope by giving a warning signal, a “divergence” occurs. Additionally to the convergence/divergence concept, momentum is also used to identify overbought/oversold conditions. This concept is quite simple. If we introduce a regression line and consider it as the trend, prices will always move up and down this line. When prices deviate considerably above and below this imaginary regression line, they will come back. Therefore, price action will be constantly crossing the trend from above and from below. When prices deviate considerably above the trend, we use the term “overbought”. Overbought in this definition is the same as expensive. On the contrary, if prices deviate considerably below the trend, we call this an “oversold” market, and oversold is the same as a cheap or a low-priced market. Market technicians have designed a lot of counter-trend indicators or oscillators to identify whether a market is oversold or overbought. The idea is buying an oversold market and selling an overbought market. These anti-trend indicators (oscillators) have been devised to eliminate the trend and show only the oscillations of price around the trend. This idea is expressed in one of the major technical principles of Martin Pring “the use of momentum indicators can warn of latent strength or weakness in the indicator or price being monitored, often well ahead of the final turning point.” However, market technicians should be careful when using these oscillators, because they must be used to confirm the existing trend. We must always be able to determine the trend, and once the trend is properly defined, we could apply oscillators as secondary evidence to confirm the trend. At least, this is how Charles Kirkpatrick recommends using technical oscillators. This idea is also expressed by Martin Pring in one of his major technical principles “it is of paramount importance to use momentum analysis in conjunction with some kind of trend-reversal signal in the price series itself.” . How successful are Momentum Indicators? Academic research is not very useful for market technicians because these studies are focused on determining whether price movement is random or not. Besides, academic studies are almost exclusively focused on moving averages, forgetting about the rest of the indicators. An example of how practitioners and academics diverge is in the risk concept. The academic concept of risk is based on the standard deviation (volatility), while traders, technical analysts, and money managers rely on maximum drawdown (MaxDD) to measure the risk of their strategy. Another example is how volatility is defined, academics employ standard deviation to measure volatility, while traders, technical analysts, and money managers use also the bar range or some similar concepts as the true ranges (ATR) to measure volatility. CMT I. 2015 Topic 6. Chart Pattern and Analysis. However, Charles Kirkpatrick states that academic research can be useful to market technicians in order to determine the direction in which to look for means of profiting from technical analysis, “if a particular indicator shows no advantage over the random hypothesis, it should be treated with considerably more skepticism than one that does show some statistically relevant results.” In the next section we are describing the most common price momentum oscillators. 6.14.1. Indicators vs. Oscillators. Although the meaning is the same regardless of the author, there are some differences in the relationship between oscillators and indicators. In this course we will use both words interchangeably. Martin Pring. He makes no difference, so the terms are used as synonymous. John Murphy. He considers that oscillators are anti-trend or counter-trend indicators which oscillate between 0 and 100 showing phases of overbought and oversold conditions, so the RSI or the Stochastics are oscillators, while a moving average is an indicator. Charles Kirkpatrick. In his book, he also embraces the same consideration as John Murphy. According to these definitions and my own experience, I think the best way to describe the difference between indicators and oscillators is the following: Indicators are divided into trend-following indicators, counter-trend indicators and volatility indicators, and oscillators are just the counter-trend indicators. Therefore, all oscillators are indicators, but not all indicators are oscillators. Note that this is not the only way to classify indicators and oscillators. 6.14.2. Momentum Principles (Martin Pring). Momentum is a generic term that can be applied to many different indicators: ROC, RSI, MACD, etc. There are two broad ways of looking at momentum, the first one uses price data for an individual time series; it is then manipulated in a statistical form that is plotted as an oscillator. We call this “price momentum”. The second is also plotted as an oscillator, but is based on statistical manipulation of a number of market components, such as the percentage of NYSE stocks above a 30-week moving average. This measure is referred to as “breadth momentum”. It is an accepted practice to use daily data for identifying short-term trends, weekly data for intermediate trends, and monthly data for primary trends. The following description of the principles and use of momentum indicators applies to all forms of oscillators. These principles can roughly be divided into two broad categories. First, those that deal with overbought and oversold conditions, divergences, and the like, these are called momentum characteristics. Second, the identification of trend reversals in the momentum indicator itself, these are called momentum trend-reversal techniques. In this case, we are making the assumption that when a trend in momentum is reversed, prices will sooner or later follow. Momentum typically reverses along with price, often with a small lag, but just because oscillators change direction doesn’t always mean that prices will too. Actual buy and sell signals can only come from a reversal in trend of the actual price, not the momentum series. Interpreting Momentum Characteristics. Overbought and oversold levels. Oscillator characteristics in primary bull and bear markets. Overbought and oversold crossovers. Mega-overbought and mega-oversold. Divergences. Complex divergences. Failure swings. Momentum Trend-reversal techniques. Trendline violations. Momentum price patterns. CMT I. 2015 Topic 6. Chart Pattern and Analysis. Equilibrium crossovers. Momentum and moving averages. Smoothed momentum indicators. Once we have listed the ways to interpret momentum and the techniques employed to determine momentum reversion, we proceed to explain them in more detail. Overbought and oversold levels. Perhaps the most widely used method of momentum interpretation is the evaluation of overbought and oversold levels. These areas are drawn on a chart at some distance above and below the equilibrium level. The actual boundaries will depend on the volatility of the price being monitored and the time period over which the momentum indicator has been constructed and, these boundaries can be determined only by studying the history and characteristics of the security being monitored. When a price reaches an overbought or oversold level, the probabilities favor but by no means guarantee a reversal. An overbought reading is a time to be thinking about selling, and an oversold one warns that the current technical position may warrant a purchase. When a particularly sharp price movement takes place, these boundaries will become totally ineffective. Unfortunately, this is a fact of life, but by and large it is usually possible to construct overbought and oversold benchmarks that are price-sensitive. In figure 6-161, the oscillator is drawn under the price and the dotted lines represent the overbought and oversold levels (e.g. 70 and 30 for RSI and 80 and 20 for Stochastics). Points A and B are, respectively, overbought and oversold lectures of the oscillators. A Overbought Equilibrium Oversold B Figure 6-161 Source: Martin Pring. 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 a long time. In a bear market, they can do remain in an oversold condition for considerable periods. In a bull market, the price is extremely sensitive to an oversold condition. That means that when you are lucky enough to see one, look around for some confirming signals that the price is about to rally. An example might be the violation of a down trendline and so on.
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