Momentum can also be a leading indicator when divergences between price and momentum arise and can lead to some profitable, high probability trades.
Please understand that the set-ups I am about to discuss are countertrend tactics, and as such, you must employ a hard stop in the event that the trend reasserts itself and you are on the wrong side. Contrast this tactic with the principle: “Trends have a higher probability of continuation than reversal.”
When you play for a momentum divergence trade, you are always playing for a small target and playing for a possible shift in buying/selling pressure. You can find various other sites that describe the concept of divergences with various indicators, and before attempting any such trade, I suggest researching further on this potentially profitable topic.
Some of the most popular indicators for uncovering price divergences include the MACD, stochastic, RSI, Ultimate Oscillator, momentum, rate of change, price oscillator, etc. You have to discover which indicator works best for you. Indicators are used as ‘training wheels’ until you can develop an intuitive sense of determining where the buying and selling pressure (momentum of the move) are diverging with the price action. This process takes time, yet indicators can help highlight these conditions. There is no perfect indicator to do this. I am using a fast MACD oscillator in my chart examples. I also play divergences in the RSI oscillator.
In this sense, momentum precedes price in that a slowing of momentum indicates that a possible change in price is yet to come. Do not get caught in the trap of searching for momentum divergences all over the chart. Examine them at the (possible) end of mature trends for greater probability. Again, we are not seeking the end of a trend move (reversal), but just a retest and a small target. In fact, we are playing for a simple retracement swing against the direction of the prevailing trend. This illustration may help:
The top pane always shows price. In this case, we are in a mature uptrend and price is continuing higher. A situation develops where the buyers are becoming less aggressive in their momentum (force of buying pressure) and momentum is declining while price is not.
Of importance to note (and the reason behind the divergence in the oscillator) is also price based. Note the steep rise of the previous swing up (creating heightened oscillator/indicator readings) and then the more gradual rise of the second swing up (creating a lower peak in the mathematical oscillator). This sets up the divergence while the reason for it is declining momentum.
If momentum precedes price, then in this case, a decline in momentum forecasts a decline in price as the most probable swing play. If buyers are less aggressive to raise their offers, then it won’t take much effort for price to fall and those who own the stock will begin to sell.
Here are some charts which highlight momentum divergences:
Divergences are difficult to quantify for a mechanical system, so this is one area discretionary traders may have an edge over programmers.
Chart #1: EBAY Daily (end of 2006). With momentum (buying pressure) decreasing, a countertrend divergence trade sets up to test the most recent swing low. Target achieved.
Chart #2: EBAY 60 min chart (October 2006). Buying pressure (momentum) is declining and we can play for a small target with a tight stop.
Chart #3:15 min chart (March 2-6, 2007). After declining for a few days, a four-point touch divergence develops in the oscillator and a flatline base forms (this is where experience over oscillators triumphs – the decline in selling momentum is best picked up by the oscillator, yet the basing area is easy to spot on the chart). Even though price continued above our target, the divergence play is only good for a small target. Note the new momentum high and reaction against it on this 15 minute chart.
I did want to highlight another point through the use of various time-frames. Divergences and momentum concepts are valid across all timeframes.
There are a few caveats to be aware when identifying momentum divergence plays:
- Momentum divergences are invalidated (and nonexistent) in rangebound, consolidating markets
- Only look for momentum divergences in the context of a mature trend (however short the time-frame)
- Momentum divergences work best after a “three-impulse” pattern in a trend
- Momentum divergences can be used in conjunction with Bollinger Bands or Keltner Channels (for increased probability)
- Momentum divergences are to be played for a SMALL target (price correction) and NOT for a reversal in trend direction
- The best divergences resemble “double-top” or “double-bottom” chart patterns
- Keep a tight stop in the market close to entry in the event that the strong trend reasserts itself and causes great losses.
- Exit divergence trades which do not resolve within 15 bars (create a time stop parameter)
Trading momentum divergences is a complex strategy and should only be attempted after repeated exposure and internalization of the price behavior that sets up the pattern.