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MOMENTUM, RATE OF CHANGE, AND SMOOTHED RATE OF CHANGE
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When greed or fear grips a mass of traders, the crowd surges. Oscillators measure the speed of that surge and track its momentum.

Technical indicators are divided into three main groups. Trend-following indicators help identify trends. Oscillators help find turning points. Miscellaneous indicators, such as the New High-New Low Index, track general changes in mass psychology.

Oscillators identify the emotional extremes of market crowds. They allow you to find unsustainable levels of optimism and pessimism. Professionals tend to fade those extremes. They bet against them, for a return to normalcy. When the market rises and the crowd gets up on its hind legs and roars from greed, professionals sell short. They buy when the market falls and the crowd howls in fear. Oscillators help them to time those trades.

Overbought and Oversold

Martin Pring compares trend-following indicators and oscillators to the footprints of a man walking his dog on a leash. The man leaves a fairly straight trail —like a trend-following indicator. The dog's trail swings right and left as far as the leash allows — like an oscillator. When the dog reaches the end of its leash, it is likely to turn and run the other way.

You can follow the trail of a man to find the trend of the pair. When the dog deviates from that trail by the length of its leash, it usually turns around. Usually, but not always. If a dog sees a cat or a rabbit, it may become excited enough to pull its owner off his trail. Traders need to use judgment when using oscillator signals.

An oscillator becomes overbought when it reaches a high level associated with tops in the past. Overbought means too high, ready to turn down. An oscillator becomes oversold when it reaches a low level associated with bot­toms in the past. Oversold means too low, ready to turn up.

Overbought and oversold levels are marked by horizontal reference lines on the charts. The proper way to draw those lines is to place them so that an oscillator spends only about 5 percent of its time beyond each line. Place overbought and oversold lines so that they cut across only the highest peaks and the lowest valleys of an oscillator for the past six months. Readjust these lines once every three months.

When an oscillator rises or falls beyond its reference line, it helps a trader to pick a top or a bottom. Oscillators work spectacularly well in trading ranges, but they give premature and dangerous trading signals when a new trend erupts from a range. When a strong trend begins, oscillators start acting like a dog that pulls its owner off his path.

An oscillator can stay overbought for weeks at a time when a new, strong uptrend begins, giving premature sell signals. It can stay oversold for weeks in a steep downtrend, giving premature buy signals. Knowing when to use oscillators and when to rely on trend-following indicators is a hallmark of a mature analyst (see Section 43).

Types of Divergences

Oscillators, as well as other indicators, give their best trading signals when they diverge from prices. Bullish divergences occur when prices fall to a new low while an oscillator refuses to decline to a new low. They show that bears are losing power, prices are falling out of inertia, and bulls are ready to seize control. Bullish divergences often mark the ends of downtrends.

Bearish divergences occur in uptrends — they identify market tops. They emerge when prices rally to a new high while an oscillator refuses to rise to a new peak. A bearish divergence shows that bulls are running out of steam, prices are rising out of inertia, and bears are ready to take control.

There are three classes of bullish and bearish divergences (Figure 28-1). Class A divergences identify important turning points —the best trading opportunities. Class B divergences are less strong, and class C divergences are least important. Valid divergences are clearly visible — they seem to jump from the charts. If you need a ruler to tell whether there is a divergence, assume there is none.

Class A bearish divergences occur when prices reach a new high but an oscillator reaches a lower high than it did on a previous rally. Class A bearish divergences usually lead to sharp breaks. Class A bullish divergences occur when prices reach a new low but an oscillator traces a higher bottom than during its previous decline. They often precede sharp rallies.

Class B bearish divergences occur when prices make a double top but an oscillator traces a lower second top. Class B bullish divergences occur when prices make a double bottom but an oscillator traces a higher second bottom.

Class C bearish divergences occur when prices rise to a new high but an indicator stops at the same level it reached during the previous rally. It shows

Types of Divergences

Divergences between prices and indicators give some of the most powerful signals in technical analysis. Divergences are defined by the differences in height or depth of prices and indicators.

Class A bearish divergence-prices reach a new peak while an indicator reaches a lower peak. This is the strongest sell signal.

Class A bullish divergence-prices fall to a new low while an indicator stops at a more shallow low than before. This is the strongest buy signal.

Class B bearish divergence-prices trace a double top while an indicator reaches a lower peak. This is the second strongest sell signal.

Class B bullish divergence-prices trace a double bottom while an indica­tor traces a higher second bottom. This is the second strongest buy signal.

Class C bearish divergence-prices reach a new peak while an indicator traces a double top. This is the weakest bearish divergence.

Class C bullish divergence-prices fall to a new low while an indicator makes a double bottom. This is the weakest bullish divergence.

that bulls are becoming neither stronger nor weaker. Class C bullish diver­gences occur when prices fall to a new low but the indicator traces a double bottom.

Class A divergences almost always identify good trades. Class B and C divergences more often lead to whipsaws. It is best to ignore them, unless they are strongly confirmed by other indicators.

Triple Bullish or Bearish Divergences consist of three price bottoms and three oscillator bottoms or three price tops and three oscillator tops. They are even stronger than regular divergences. In order for a triple divergence to occur, a regular bullish or bearish divergence first has to abort. That's another good reason to practice tight money management! If you lose only a little on a whipsaw, you will not suffer—and you will have both the money and psychological strength to re-enter a trade.

Momentum and Rate of Change

Momentum and Rate of Change measure trend acceleration—its gain or loss of speed. These leading indicators show when a trend speeds up, slows down, or maintains its rate of progress. They usually reach a peak before the trend reaches its high and reach a bottom before prices hit their low.

As long as oscillators keep reaching new highs, it is safe to hold long positions. As long as they keep reaching new lows, it is safe to hold short positions. When an oscillator reaches a new high, it shows that an uptrend is gaining speed and is likely to continue. When an oscillator traces a lower peak, it shows that an uptrend has stopped accelerating, like a rocket that has run out of fuel. When it flies only because of inertia, you have to get ready for a reversal. The same reasoning applies to oscillator lows in downtrends.

Momentum and Rate of Change compare today's closing price to a price a selected period of time ago. Momentum subtracts a past price from today's price; Rate of Change divides today's price by a past price.

For example, a 7-day Momentum of closing prices equals today's closing price minus the closing price 7 days ago. Momentum is positive if today's price is higher, negative if today's price is lower, and at zero if today's price equals the price of 7 days ago. The slope of the line connecting momentum values for each day shows whether momentum is rising or falling.

A 7-day Rate of Change (RoC) divides the latest price by the closing price 7 days ago. If they are equal, RoC equals 1. If today's price is higher, then RoC is greater than 1, and if today's price is lower, then RoC is less than 1. The slope of the line that connects values for each day shows whether Rate of Change is rising or falling (see worksheet, Figure 28-2).

A trader must choose the width of the time window for Momentum or RoC. As a rule of thumb, it pays to keep oscillator windows fairly narrow. Use wide windows for trend-following indicators whose goal it is to catch trends. Use narrow windows for oscillators to detect short-term changes in the markets.

Momentum and RoC share a flaw with simple moving averages — they jump twice in response to each piece of data. They react to each new price, and they jump again when that piece of data leaves the oscillator's window. Smoothed Rate of Change takes care of this problem.

Crowd Psychology

Each price reflects the consensus of value of all market participants at the moment of transaction. Momentum and RoC compare today's price (today's consensus of value) to a previous price (an earlier consensus of value). They measure changes in mass optimism or pessimism.

To find out whether a child is growing fast enough, you can measure his height each month and compare it with his height six months ago. Then you find out whether your child is growing normally, growing so slowly that you should take him to a doctor, or growing fast enough to think about applying for a basketball scholarship. Momentum and RoC tell you whether a trend is accelerating, slowing down, or moving at the same speed.

When Momentum or RoC rises to a new peak, it shows that the optimism of the market crowd is growing, and prices are likely to rally higher. When Momentum or RoC falls to a new low, it shows that the pessimism of the market crowd is increasing, and lower prices are likely ahead.

When prices rise but Momentum or RoC falls, it warns you that a top is near — it is time to think of taking profits on long positions or tightening stops. If prices reach a new high but Momentum or RoC reaches a lower top,

that bearish divergence gives a strong sell signal. The reverse holds true in downtrends.

There are times when Momentum and RoC act not as leading but as coin­cident indicators. Think what happens to a rocket when it hits an overhead obstacle. Its speed and momentum stop rising and fall together as the rocket crashes. This happens in the markets when the crowd gets hit by a major piece of bad news and this "overhead obstacle" sends RoC and prices down together.

Trading Rules

Leading indicators are like brake lights on a car ahead of you on a highway. When they light up, you do not know whether the other driver is tapping his breaks or slamming them. You have to be extra careful putting on trades using leading indicators (Figure 28-3).

•  When the trend is up, buy whenever RoC declines below its centerline
and ticks up. It shows that the uptrend has slowed down — like a train
that slows down to pick up passengers. When the trend is down, sell
short whenever RoC rallies above its centerline and ticks down.

•  If you hold a long position and prices begin to slide, see whether RoC
has reached a record peak before this pullback. A new peak in RoC
shows a high level of bullish energy, which is likely to lift the market
to its previous high or higher. Then it is relatively safe to hold long
positions. On the other hand, a series of declining peaks in RoC is a
sign of weakness —it is better to sell immediately. Reverse this
approach in downtrends.

•  A break in a trendline of Momentum or RoC often precedes a break of
a price trendline by a day or two. When you see a leading indicator
break a trendline, prepare for a break in the price trend.

Smoothed Rate of Change

This oscillator, developed by Fred G. Schutzman, avoids the major flaw of RoC. It responds to each piece of data only once rather than twice. Smoothed Rate of Change (S-RoC) compares the values of an exponential moving average (EMA) instead of prices at two points in time. It gives fewer trading signals, and the quality of these signals is better.

To create S-RoC you must first calculate an exponential moving average of closing prices (see Section 25). The next step is to apply Rate of Change to the EMA. S-RoC is not very sensitive to the length of its EMA or RoC parts. You can calculate a 13-day EMA of closing prices and then apply a 21-day Rate of Change to it (see worksheet, Figure 28-2).

Some traders calculate the Rate of Change of prices first and then smooth it with a moving average. Their method produces a much jumpier indicator, which is less useful than S-RoC.

Crowd Behavior

An exponential moving average reflects the average consensus of value of all market participants during the period of its window. It is like a composite photograph that reflects major features of the market crowd rather than its fleeting moods.

S-RoC compares each reading of an EMA to a past reading from your selected period of time. It compares the average mass consensus today to the average consensus in the past. S-RoC tracks major shifts in the bullishness and bearishness of the market crowd.

Trading Rules

Changes in the direction of S-RoC often identify important market turns. Upturns of S-RoC mark significant bottoms, and its downturns mark important tops (Figure 28-4). Divergences between S-RoC and prices give especially strong buy and sell signals.

•  Buy when S-RoC turns up from below its centerline.

•  Sell when S-RoC stops rising and turns down. Sell short when S-RoC
turns down from above its centerline.

•  If prices reach a new high but S-RoC traces a lower peak, it shows that
the market crowd is less enthusiastic even though prices are higher. A
bearish divergence between S-RoC and price gives a strong signal to
sell short.

•  If prices fall to a new low but S-RoC traces a higher bottom, it shows
that the market crowd is less fearful, even though prices are lower. It shows that the downside pressure has lessened, even though the mar­ket has fallen deeper than before. A bullish divergence gives a strong signal to cover shorts and buy.

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