Out of all of our tools, MA_Momentum is perhaps the most misunderstood and misused. Many people look at momentum only as a trend indicator, generating signals on zero line crossovers. While this is undoubtedly one task that this tool can be used for, it is only the tip of the iceberg and does not take full advantage of the smoothness and timeliness of MA_Momentum. There are many other ways to use this tool, and we would like to use this week's Showcase to demonstrate a few of these methods.
Method #1 - Divergence:
The first method is to use MA_Momentum as a divergence detector. In our case, a divergence signal occurs when price makes a new low or high which is not reflected by a new low or high in momentum. An example of bullish divergence would be a lower low in price matched with a higher low in momentum. There are four divergence signals in the above Pork Belly chart, each of which is marked with a trendline and an arrow. Divergence does not happen at each turning point, but when it does occur it tends to be a powerful signal.
Method #2 - Trendline Breaks:
Another way to use MA_Momentum is as a breakout detection device. Simply draw a trendline on descending swing highs or ascending swing lows of the indicator and look for a break of the trendline. This second chart shows the signals generated by this method. As you can see, they are very accurate. This particular technique works extremely well with MA_Momentum because it is very easy to spot pivots in such a smooth indicator. Canned momentum is so noisy that it is not always so easy to decide which points should be use to form the trendline. Due to the nature of our momentum curve, the placement of the trendlines on the above chart was nearly automatic.
Method #3 - Overbought / Oversold:
A third method of generating signals off of MA_Momentum is to use the indicator as an overbought/oversold measurement similar to Stochastics or RSI. In this third chart, we have applied the adaptive zones indicator from the Fractal Toolkit to MA_Momentum. Sell signals are generated when momentum drops below the upper band, and buy signals occur on upward breaks of the lower band.
Each of these methods has its pros and its cons, but the fact that this indicator can be used in so many different ways is a testament to its flexibility and usefulness. Which method to use depends more on the temperament of the trader in question than the qualities of the method itself. In fact, all three of these methods can be used together. There are two places on the chart when all three methods gave the same signal at nearly the same time. The first signal is in January and the second in May of 1999. In both case the signals were to go short, and in both cases the market dropped dramatically after the third signal had been recorded.
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