I wanted to include a post that highlighted examples of the market principle: “Momentum Precedes Price”. It has been suggested that this principle be restated “Increases in momentum imply price will continue in the same direction of the momentum.”

I do not refer to the indicator “momentum” in this sense, but rather pure price action. A better word might be “impulse” which implies temporary, yet significant imbalance between supply and demand. Price moves in waves and when one wave is significant in scope, it is expected that the imbalance will continue to play out in the direction of the original disturbance of balance.

Nelson Elliot (of Elliot Wave Theory fame) coined the term “impulse” to describe marked increases in momentum and noted that following an impulse wave, there tends to be (at least) three pushes up in the trend direction (with two corrective waves). While I am not an Elliot Wave theorist, the idea behind his concept is applicable.

In the first few examples, the trade I’ve found that works best is the following:

After identifying a new momentum high AND a new price high (confirmation), look to ENTER the market on the first REACTION against the price high and play for a small target: the most recent price swing high (or just beyond). Your stop is placed a tight distance below entry, which usually corresponds with a moving average or prior swing low.

This drawing may help clearly see the pattern I am trying to convey. I call this the “Impulse Buy“.

-

Caterpillar. Weekly chart.

Point 1: Following a short consolidation period, we see a quick thrust of price upwards, creating our initial “impulse” condition. Our bottom panel indicator prints a higher high along with price. We look to enter the trade on the first reaction against this initial impulse. Your entry depends on your risk tolerance: aggressively would have entered at the moving average ($23 – green bars) while conservatively would have waited for price to turn-up (the yellow bars – also $23). Price “shook out” below the moving average in this case.

Stop placement is also dependent upon risk tolerance. Overly conservative may have placed stop just below moving average (and would have been stopped out) while overly aggressive would have placed stop below most recent swing low at $18.

If we look simply at price bars, notice the large expansive bars that occur upwards – range expansion also indicates an ‘impulse’ or momentum move may be underway.

The target is the most recent swing high (or just beyond) which formed just below $26.

Chart point #2 indicates our target which has been achieved. After a new price and momentum high, new price highs are likely yet to come.

Here are some other examples, but fewer comments. The play is the same. Identify impulse (range expansion or new momentum high), wait for pullback, play for the most recent swing high. Exit.

Some observations: The charts are purposely simplified to highlight the impulse and momentum conditions, and it would be wise to look at larger charts to see these moves and add volume analysis.

Commentary:

A) DIA Weekly Jan 2005: Impulse and two-bar range expansion out of consolidation. Entry: $104. Target: $108.
B) GOOG Daily Sept 2006: Gaps helped serve as initial impulse, along with momentum readings, consolidation, and then retest (and beyond) recent swing high
C) CTSH Daily Aug 2004: Gap and two-bar expansion (along with momentum reading) serve as initial trigger. Target of recent swing high achieved.

The idea behind these patterns is that an initial impulse move will result in a corrective reaction against this move (to shake out the weak hands), yet price will reassert itself (temporarily) in the direction of the impulse and retest (or exceed) the most recent high.

For me, I have found more success in these patterns when I play simply for the retest only. If you get greedy and expect a new swing higher, you may be disappointed. It is best to enter your position, enter a hard stop, and enter a hard profit target. This keeps emotions at bay at trade entry, trade development, and trade exit.

The type of trade discussed here is a cross between a “trend retracement entry” and a “retest” entry, so be aware of the distinction and how they overlap.