Tom Hougaard teaches the basics of momentum indicators and shows practical examples of how he uses these tools in his own Forex trading.

Transcript:

Introduction:
As technical traders we have a vast array of tools at our disposal, and one of those tools are called oscillators, and in this particular chapter I will take you through what oscillators I use for my own personal trading.

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A momentum indicator records the speed of prices moving over a certain time period. At the same time Momentum indicators track the strength and the weakness of a trend as it progresses over a given period of time.

Some of the most popular momentum indicators are the:

• RSI
• MACD
• STOCHASTICS
• MOMENTUM
• RATE OF CHANGE
• CCI

What these indicators have in common is that they attempt to measure two things:

The first thing they attempt to measure is whether the market is overbought or oversold. In order to do that they make use of bands, which theoretically indicates if the asset is overbought or oversold?

The second thing that a momentum indicator attempts to measure is a directional divergence between the price and the momentum indicator.

At this point I need to make a couple of things clear to you. First of all I do not believe in the notions that a market is “overbought” or “oversold”. I have seen way too many markets stay oversold or overbought for months on end, and it made no difference to the traders in the market place. I have a long time ago stopped placing trades in the market, merely because a momentum indicator suggest that a particular market is oversold or overbought.

The other thing I need to make clear to you is that all the momentum indicators are pretty much the same. I know some die hard technicians will disagree with me, but remember, I am NOT a technician. I am a trader who uses technical analysis to get into and out of the market. So I have thrown away all the momentum indicators and I use just one now, which is the Stochastic. It works for me and I am going to teach you how I use it in my trading. But I am still going to show you some of the other momentum indicators and how to interpret them.

I was never a big fan of momentum indicators until my trading partner David Paul taught me the same strategy that I am going to teach you in chapter 12. When I saw this technique in action, I was hooked and I think you will be too. It is exceptionally powerful and has a good track record.

But before we can get to that, we need to go through the basics of momentum indicators.

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All the momentum indicators are, as I said earlier, pretty much the same. They all have the same properties, and the most important aspect of each is referred to as divergence.

We will talk a lot more about divergence as this chapter progresses. Right now it is time to introduce you to what a momentum indicator is. On the chart you can see the price unfolding and underneath it you see the momentum indicator. This particular indicator is the RSI.

It spans from 0 to a 100. The theory states that once the market becomes oversold, it is time to buy, and once it is overbought, it is time to sell short or get out of the market. This is confirmed by a trend line break of the price chart. As I say, when I show people this chart: “if only it was that easy”.

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There is no point in keeping you in suspense anymore. I need to get to the point of this chapter and that is to teach you about divergence and reverse divergence. Once you understand this, you will be much better equipped to understand and appreciate the trading strategy presented in chapter 12.
In the chapter on the principles of price action I stated that momentum precedes price. In other words if momentum was making new highs, then there was a high probability that price itself would make new highs.

The opposite is true as well. If momentum was making new lows, then I would expect price to follow and make new lows too.

What divergence means is that one of the two components is diverging from this principle. For example, on the chart you see on the screen right now, price is making new highs, before the trend turns down. But while it is making new highs, the Momentum indicator used here, called the RSI, is not making new highs.

As a matter of fact the RSI is topping out before the price is topping out, and RSI begins to make lower highs and lower lows. This is an example of divergence, and it is a powerful signal to the trader that the current trend may shortly run out of steam and turn.

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Let’s take another example. Repetition is after all the mother of all skills, and I need to make sure you have several examples to refer to, so you can start finding the trading setups in the live markets.

On this chart you can see how price is making a double bottom, but underneath the price you see how the RSI is making a slightly higher bottom. This is another example of a divergence. Price fails to break to new lows and this bullish action is confirmed by the RSI, which is now making bullish overtures, by making a higher low.
I think it is important that you keep in mind that what we are looking for is a sign that momentum is indicating a reversal is at hand. But as traders we still have to take into account that we have to protect ourselves, and that we can’t simply start buying or selling short indiscriminately, just because we have seen a divergence unfold on a chart.
When we see a divergence in a market, it is the markets way of telling us that the internal dynamics of the price action may not be as strong or as weak as the price action alone lets us believe. However, I still have some tough choices to make.
I have to consider where to get into the market, if I want to enter into a position. I also have to consider my exit strategy, in case that the market does not cooperate with my position. I will prefer to enter the market on some sort of reversal signal in price itself, but that may not be present. There may be no reversal signal for me to work with, and I have to take these factors into account when I trade.

So whether I have a double top, or a head and shoulders pattern, or a triple bottom to work with, and the divergence is confirming the potential for a trend reversal, I still have to take all of these factors into account, before I place the trade. Now sometimes this decision is made in a split second, and sometimes I will sit and watch the market for half an hour, waiting for just the right moment to strike.

You have probably heard this before, but it is so true, that it is worth repeating: Trading is simple, but it isn’t easy. I was once asked by a family member to describe how I day trade the market. I told my nephew that being a trader is somewhat akin to being a hunter. You sit patiently, and quietly, waiting for an opportunity to strike. Once an opportunity presents itself, you check that all the parameters that you can control yourself are in place. And then you are in a position to strike.

It doesn’t always mean that you are going to be successful. This morning I was attempting to buy the Euro Yen, and I had in mind that I wanted to be a buyer at a certain price level. If it hit this price level, my order to buy the Euro Yen would get triggered. What happened was that the currency pair came within 2 pips of my entry point, and it then reversed back up again, gaining more than 90 pips in moments, but without me in the position. Although it can be upsetting as it happens, you have a sense of satisfaction, when you review the trading day, that you followed your trading plan.

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We have spoken about divergence now, and I hope you by now have a good understanding of what it is about. But I am going to have to be honest with you. It is not my favourite momentum indicator.

As a matter of fact the reason why I am not overly keen on divergence is because I know there are so many traders looking at it. Instead my trading mentor David Paul has taught me a different kind of momentum indicator, which I feel have a much greater impact on my trading.

It is called Reverse Divergence.

A reverse divergence is a momentum indication on par with the normal divergence, but with a twist. With normal divergence we are watching for price to make new highs or new lows, but the momentum indicator, such as the RSI, is not confirming this. The momentum indicator is failing to make new highs or lows.

With a reverse divergence the opposite is true. With reverse divergence price has failed to make new highs or new lows but the momentum indicator is making new highs or new lows. So while price is making a top which is slightly lower than the previous top, the momentum indicator is making a new high.

On the chart on the screen, you can see an example of that. On the price side of the chart you can see how the market is making a new high, which is signified by point A, and then it proceeds to make a lower high, signified by point B.

At the same time the RSI is making a high at point A, and a higher high at point B. This is a reverse divergence setup, and like the normal divergence it is an indication to you as a trader that the market may be running out of steam, and that a reversal is on the cards.

The same principle applies to the downside. The price action is trending lower, but is making signs of reversing, by printing a higher low. However, the momentum is continuing to make lower lows.

In chapter 12 I will give you the full details of the trading strategy that I utilise when trading reverse divergences, but I want to describe the setup in my own words now, and then we can go into the technical details in chapter 12.

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My reverse divergence setup essentially involved buying into a market which is already trending higher, or selling short a market which is already trending lower.

How do I decide if a market is trending higher or lower? I use a trend indicator. It doesn’t have to be terribly sophisticated. For me it is enough to use a simple moving average. It shows the average price over a period of time, which I decide. I use the 89 period moving average as my trend indicator. So whether I trade this pattern on a 5-min chart or a 15-min chart, or an hourly or even a 4-hour chart, I will use the 89 period moving average as my trend signal.

What I am looking for is as follows:
My trend indicator needs to point in one direction, up or down. If the market is trading sideways, then I stand aside and look elsewhere. If the trend indicator is pointing higher, I will be looking to buy the market. The market should be trading above the 89 period moving average as well.

I am now waiting for the market price to make a higher low, or a rising low, but at the same time, I am looking for the momentum indicator to make a falling low. This is show on the chart on your screen now.

Here you can see the market trading above the 89 period simple moving average, while the oscillator is making falling lows. My goal is to trade in the direction of the prevailing trend.

Once I see a setup of this nature I will wait for the market to give me a clue that it is ready to resume a move in the direction of the prevailing trend. I will be watching for a candle chart pattern to enter the market, or the market coming down to touch an area of support.

The opposite holds true for a bearish setup. Let’s take a practical example from a recent trade I placed in the market. On this 2-hour chart of the Euro against the US dollar, you can see how the market is trading below the 89 period moving average. As such I am looking for opportunities to sell short.

On the price chart the market has gone from being range bound to breaking down and I am able to draw a blue line, signifying that the market has made a high and a lower high.

On the momentum indicator where I use the stochastic for this setup, you can see how it is making a series of rising highs. I have drawn a blue line on the momentum indicator, signifying that it is making a rising high.

How this should be viewed as follows: The peak on the price chart corresponds with a peak on the momentum chart. The secondary peak on the price chart, which is lower than the first peak on the price chart, signifies a downtrend, but on the momentum indicator the corresponding peak is higher than the previous peak.
And this is what is known as a reverse divergence.

The red line you see in the middle of the chart image is my attempt to draw a line where the market will find resistance. There is not specific law to drawing this line, and it is largely the result of trial and error, and years of experience.

In this particular trade I saw the reverse divergence and I knew I wanted to short the market. I went short just around the red line, with a stop above the previous peak. My risk in this particular trade was 25 pips. I don’t use a fixed stop loss when I trade. Rather I gauge each potential trade individually, and asses how much tolerance to give the stop, and I adjust my position size accordingly.

I hope this has given you an idea of how I trade, and how I use momentum together with a simple trend indicator to get me into trades. We will look into this in greater detail in chapter 12.