Every time a market climbs to new highs, some questions pop in everybody’s mind, such as: why is the market moving up, or is it too late to buy? Also, if I already have a long position, is it too early to sell. These are all valid concerns, and momentum indicators’ or oscillators’ major role is to identify trends that are running out of steam before the obvious thing happens: correction.
Speaking of markets that may be overbought, let’s take a look at the Australian – US Dollar pair. At the date of this writing, Wednesday, April 27th, the Aussie reached the highest point against the greenback since 1983, the time when the Aussie was allowed to float freely. There are fundamental reasons for the Aussie’s strength, such as the Reserve Bank of Australia (RBA) holding the interest rate at 4.75%, a high number considering that the US Federal Reserve (the FED) set the discount rate near 0%. This rate difference encourages foreign investments into Australian assets. However, the greenback is not the only one who suffers. On the Australian side there are losers too, such as exporters and tourism. Many analysts don’t expect the FED to increase the rates anytime soon, and the Chinese are threatening to diversify their currency reserves away from the US dollar, which, from a fundamental perspective, will cause the dollar to further devalue.
However, I have seen markets temporarily diverge from their fundamentals many times. When price corrections take place, the most frequent reason cited by the media was “technical correction due to overbought conditions,” meaning that traders became uncomfortable with their long positions and decided to pocket some of their profits.
Could Technical Analysis Paint a Clearer Picture for Us?
One of the momentum indicators’ claim to fame is that they are able to read between the lines, so to speak, and provide warning signals of latent strength or weakness in a market, often prior to a price turning point during an uptrend. As a general rule, markets take a longer time to build up and less time to correct; therefore, momentum indicators lead during uptrends and tend to lag during downtrends. This characteristic makes them priceless during uptrends. Some other things to consider are:
– Oscillators have to be interpreted in conjunction with trend reversal analysis of the underlying price itself, for example by applying moving averages crossovers.
– Trend-line violations work with momentum indicators the same way a trend line violation works with the underlying. However, a reversal in momentum does not translate to a reversal in price.
– When analyzing markets via oscillators, one has to use keen judgment. One method to eliminate some subjectivity is the use of moving averages to smooth the oscillator and eliminate whipsaws.
– Divergences: if the price moves up, but the momentum indicator moves down or sideways (for example), I take it as a warning sign that the price uptrend may be ending; this is in fact one of technical analysis’ golden rules.
– “Momentum” is a generic term and can be applied to many oscillators: MACD, RSI, KST, ROC to name few of the most well known ones, below is a short recap:
Moving Average Convergence-Divergence (MACD) is a versatile oscillator that can be used for outright buy and sell signals or for gauging a market’s strength. MACD seems to work well on longer time frames, such as weekly. Although MACD gives fewer signals a year on a weekly chart, they are more reliable. As a general rule, it is important to double check that the daily signals are aligned with the weekly signals. Most default settings for MACD are 12, 26 & 9, but you can customize this indicator.
Relative Strength Index (RSI) is displayed on a scale from 0 to 100, with overbought default value of 70 and oversold default value of 30. Like any other oscillator, RSI is not intended to be used alone, it is rather a confirming type of indicator. RSI’s main purpose is to point out overextended market conditions. For example, an RSI reading above 70 could mean sell, and a reading below 30 could mean buy. Over the years, traders have found new interpretations and parameters for the old RSI. Richard Tortoriello argued that RSI is just another measure of “relative strength,” and a stock should be held if RSI value is high instead of sold. Therefore a low RSI reading means that the trend is weak and you should consider staying on the sidelines or selling the stock if you own it. According to Tortoriello’s research on stocks from 1992 to 2007, buying stocks with high RSI produced an average annual return of 16.7 percent compared to S&P 500 return for the same period of 11.1 percent. Moreover, Tortoriello’s portfolio experienced better returns than the market approximately 70 percent of the time. Another key difference is that Tortoriello uses RSI as an intermediate time frame oscillator, calculated on 28-week period, rather than 14-day period. This is another significant divergence from Wilder’s view of RSI as a short time frame oscillator.
The stochastic indicator is based on the premises that during uptrends, the closing prices tend to gravitate near the highs of the period, and during the downtrends, the closing prices tend to stick closer to the low of the period. This pattern holds particularly well when trends are running out of steam.
Rate of Change (ROC) is considered the father of the momentum indicators, and it is easy to calculate and understand. ROC measures the speed of a decline or advance over a certain time period. It is calculated by dividing the price in the current period by the price from N periods ago. A rising ROC means increased velocity, while a declining ROC means a loss of momentum. Increased velocity is bullish and momentum loss is bearish. The most reliable time spans are 12-month ROC for long-term trends, 3 or 9month for intermediate trends and 10, 20, 25 or 30-day spans for shorter time frames. The drawback of ROC is lack of sensitivity to price turning points. The Know Sure Thing indicator is trying to overcome ROC’s shortcoming by using four ROCs of different time spans.
The Know Sure Thing (KST) can be applied on any time frame, from intra-day to monthly KST and it is useful in relative strength analysis. The basis of Know Sure Thing is the smoothed ROC (rate of change) on four time frames: 9, 12, 18 and 24-period each smoothed by a 6 period moving average. A moving average is calculated by dividing the sum of closing prices over a period of time by the number of periods.
Each ROC is weighted according to the time length. The weights for each ROC are 1,2,3,4; where the 24-period ROC has the largest influence. For monthly charts, when a 24-month period ROC is used, it becomes more significant because 24 months represents half of a 4-year business cycle. One major drawback is that KST is an obscure oscillator and not all charting software provides it.
Technical Momentum Point of View – AUDUSD
The AUDUSD pair chart below shows a mixed picture: on one hand, Stochastic and ROC point towards divergence, and on the other hand, RSI and MACD are still going strong. The moving average crossover (20-day SMA and 9-day EMA) buy signal is still intact, even though it has been in place for more than a month, meaning that we may see more strength in the Australian dollar.