Momentum Oscillators (2): Examination of Some Common Uses
In this article we are going to look at some common uses of momentum oscillator, specifically the Rate-of-Change (ROC) oscillator. The use of Relative Strength Index (RSI) is similar and will not be disccused here. As in the case for moving average, we will try to examine each case by “translating” the statement into English and then see if they make sense at all.
1. The momentum indicator ROC can signal an overbought or oversold condition.
This has some truth in it. If the momentum has reached a maximum (or minimum values), it means the price has been increasing (or decreasing) rapidly in the past N days, and the speed of price increase itself is increasing. The fast increase (or decrease) might be due to some news, so the peaks (or valleys) are signalling us to watch for further action.
But there is no way we can tell from the ROC or chart alone what direction the price is going. If the price has been increasing rapidly in the past, it could mean an overbought condition has been reached (a common use of ROC) so the price might be coming down. Or it could mean the trend is going upward, so although there might be a pullback, the price will to continue to rise. Note that either way is possible with ROC peak.
The converse is also truth. It is often said that oversold condition can be detected by the minimum values of he indicator. The problem is the minimum values could mean oversold condition, but it could also mean a down trend is starting.
Take a look at the chart of QQQQ for the past 2 years. Our eyes could be fooled to look at the valleys and think that if we had bought every time a valley was formed, we would have been rich. But watch closely. Don’t forget the common use of ROC also suggests to sell with peaks. If you had sold every time a peak was formed, you would have been broke.
http://finance.yahoo.com/q/ta?s=qqq&t=2y&l=on&z=l&q=l&p=&a=p12,v&c=
The reason that going long works but not going short on this chart is because the trend was upward. Had it been a downtrend the opposite would have been true. You might say that’s why we use the oversold conditions in an uptrend. But you do not know the trend beforehand. It is not that the valley acts as oversold in an uptrend, it is just that in an uptrend there are always pullbacks so the ROC is simply showing the pullback.
Below is another chart with ROC, except this time the price is decreasing. There are plenty of valleys before June 10, and if we thought they mean oversold conditions and bought on those, we would have lost a lot. BP was having problem with the oil spill, so people were selling, so the price dropped rapidly and so we had valleys on the ROC chart. They weren’t oversold, however. The ROC is only telling that the price is decreasing. It cannot tell whether it is an oversold or not in real situation.
http://finance.yahoo.com/q/ta?s=BP&t=6m&l=on&z=l&q=l&p=&a=p12,v&c=
On July 15, there is a peak. We could have said from the chart that it was an overbought and sold BP. If we did, we would lose because BP went up. The reason it went up was because they seemed to have contained the oil spill. At least the initial test showed some success.
I hope I have illustrated enough here (and through my previous articles on moving averages) that news and events determine future price, and the price will be reflected in the chart, but the chart by itself does not determine future.
In summary, the ROC peaks or valleys can signal a watch condition, but it cannot tell the direction accurately. Future direction is determined by what is causing such a price increase and how the market reacts to it.
2. Bullish signal when Momentum rises above 0 for ROC (or above 1 for RSI)
This is really a very weak use of the momentum indicator. Think about this. What does it mean by the ROC rises above zero. Let us translate the statement into English: ROC rising above 0 simply means prices have changed from decreasing to increasing (see my previous article), but does that alone mean a bull signal? Are you really convinced that when the price action has changed from decreasing to increasing, it means the market is bullish and it is a time to buy?
3. In an uptrend, look for oversold (in an uptrend, buy if ROC turns upwards when below zero).
The problem is we don’t know whether it is uptrend or downtrend. This is why we are trying to use any indicator, remember? How can we now assume there is an uptrend and then try to use the indicator?
On the other hand, if you can somehow tell that is uptrend, then it doesn’t matter whether you use ROC to determine your buy signal. You can say use percent pullback or Fibonacci retractment for your buy signal. As with any indicator, you won’t be accurate 100% but you will do pretty good because it is in an uptrend. But the problem is you don’t know whether it is indeed an uptrend. Frankly, if you know how to confirm an uptrend, you will be the richest person in the world even without the ROC or any other indicator.
Textbooks and internets are full of statements like “in an uptrend, use the ROC for oversold condition” or the converse of it. Yes, they sound good, but only if you can tell whether you are in an uptrend or not.
Summary for ROC momentum oscillator/indicator:
- Zero crossing doesn’t mean much.
- Peaks or valleys often indicate some news/events that caused rapid price increase/decrease.
- Peaks and signal can indicate “watch” signal, but other information is needed to make decision.
- The ROC (or RSI) oscillator cannot successfully tell an overbought or oversold condition.
In other words, we can use the RSI and start our process of research. We need to look at what has happened that caused the price increase/decrease and interprete the news if available. We need to also look at the overall market situation.