By Linda Raschke
Much has been written about the use of momentum oscillators in highlighting retracements in a trend or momentum divergences. This article will show an entirely different way that momentum oscillators can be used.
Many traders become conditioned to only initiating trades counter the short-term trend. For example, when buying a retracement in an uptrend, we are entering against the direction of a short-term downtrend with the intent of establishing a position in the direction of the higher time frame trend. The advantage of this strategy is that it allows the trader to buy on the bid rather than “chasing the market” and buying on the offer. This strategy works best in active, swinging markets. However we may not always be able to recognize when the market environment has changed to a momentum environment, and therefore when different types of strategies should be employed. In a normal environment, it pays to be conscientious about initial trade location. However, in a momentum environment, the name of the game is “Get the trade ON”! Too often, a trader who is unable to switch gears will be left in the dust watching the market runaway without him. In this type of market environment, the first reaction usually does not come until after the market has run a good bit.
SP500 Index – In the middle of the chart, the market had made a LOWER low and the 3/10 oscillator had made new momentum lows. Any short at this point would have led to a small win. The better trades come when you can draw converging trendlines on a chart formation on the higher time frame. These are the kind of trades where the market never looks back; any trader waiting for a retracement would not be able to get on board until much lower levels.
Let’s explore a way to switch gears and use momentum oscillators in a different manner to initiate a trade at the beginning of a momentum move. Sometimes reframing a situation helps free a trader from the “freeze up” syndrome. In this case, we are going to look at a how and when to buy a momentum oscillator HIGH and still have confidence that we will have a winning trade. The key will be to frame out the technical structure before hand.
Many times the best momentum moves come when a market breaks out of a chart formation or a long sideways line. But here is the rub: what is the ideal way to enter a breakout trade? Two of the more popular ways to enter are by using a channel breakout such as buying the highest high of the past number bars, or a volatility breakout, such as adding an average true range function to a specific price level. However, both of these methods are prone to false breakouts, and since initial stops for these types of entry methods are wide, losses can be large for losing trades unless a trader has quick reflexes and is adept at recognizing action that indicates an immediate lack of follow-through. Quite frankly, I do not want to have to rely on reflexes to make my living when I am old and gray, since I anticipate continuing to trade for many years to come. Let’s find a different way!
Gold – Breakout from long sideways line where the price had traded multiple times through $400 was confirmed by new momentum highs in the oscillator. A trader should have bought half on new highs in the oscillator and entered the balance on the shallow consolidation. Note: The previous upside breakout on March 9 was not confirmed by new highs in the momentum oscillator.
It is ideal to use a true momentum oscillator such as a moving average oscillator as opposed to an oscillator such as an RSI or a stochastic that is set against a fixed scale. However a trained eye will be able to see the same thing in any oscillator. I have always used the difference between a 3 and 10 period simple moving average and that is what is used in the following chart examples.
First, before making a trade, it is important to qualify the volatility conditions. The first condition for our trade setup is that volatility has been contracting and the market has formed a “sideways line”. This is analogous to the price trading multiple times back and forth through a fixed level, which is what happens when the market consolidates and forms a chart formation. The ideal breakouts will occur when a trader is able to draw converging trendlines around a chart formation. If price penetrates a trend line, this does not guarantee a true breakout and there is nothing more frustrating than entering a premature breakout.
Once the potential breakout formation is identified, go down to a lower time frame. For example, if the chart formation is on the daily charts, go down to a 15 or 30-minute time frame. If a trader sees an extended consolidation on a 5-minute SP chart, go down to a 1- minute time frame. The lower time frame is our trigger to enter the trade. We will buy half a position AT THE MARKET when both the price and the momentum oscillator on the lower time frame make new highs. A bid for the balance is immediately placed a few ticks below the initial entry price. Sometimes the balance of the trade may not be filled in which case the trader can still add on the first pullback from a higher level. But, the main point is: get at least PART of the trade on!
Nasdaq Index – There were two opportunities to buy the Nasdaq Index. On the first upside breakout, a stop would have been placed at the previous swing low. As long as the oscillator makes new momentum highs, the price will keep going higher. The second momentum high is again a case of where the market never looked back; a trader waiting for a retracement to buy would have been left in the dust.
Momentum precedes price. By waiting for a momentum oscillator to make new highs, a trader has doubled his confidence level that the price action will have follow-through in the direction of the breakout. Short-term momentum precedes longer-term momentum. Evidence that the market is tipping its hand will always be detected on the shorter time frames first. An oscillator will make new momentum highs on a 15-minute chart before it does on the hourly charts.
No methodology would be complete with out risk and trade management guidelines. Stops in the case of an upside breakout should be placed at the price level that coincided with the last oscillator swing low. More often then not, the market will make “Three pushes up” and the trader will have entered on the first wave. Since the trade was entered “at the market” (thus costing the trader in efficiency), an effort should be made to exit by placing an offer to remove part of the trade as the price is rising.
This is not meant to be a trend following method, but rather one more tool in the short-term discretionary trader’s toolbox. Taking a piece out of the middle of a momentum move is a form of swing trading too. Swing trading is nothing more then using the markets most immediate price action to forecast the next move or swing – and this can apply to any time frame, be it 1-minute charts or a weekly chart.
Trading is a matter of style and everything we do is a matter of tradeoffs. A trader sacrifices initial trade location in exchange for higher confidence that the trade is working. A trader who tries to buy the lower end of a trading range may have superior trade location. However, the odds of capturing an immediate quick gain might be a lot less then the trader who buys at a higher price but has the added benefit of the market momentum in his favor. Both ways can be right – it is simply a matter of style. In the long run it will be the management of the trade after the entry that counts more then the initial entry point.