the MACD line and selling when it crosses below. The signal line could be used to produce countertrend signals, as is common when using the stochastic (discussed in the section "Oscillators" in this chter), by selling when the MACD crosses the signal line heading down while still above zero.

Because both moving averages are lagged, the peaks identified by the difference between the two will also be lagged. This is contrary to the usual pu ose of the momentum indicator, which is to identifj the precise time when an extreme has been reached. Looking at Figure 6-3c (bottom panel), the difference between the 10-day and 40-day moving averages is shown as a histogram, a form most commonly used for the MACD. it can be seen that the peak formed by the widest difference between the two moving averages is generally a few bars to the right of the peak seen on the price chart and the simple momentum line in Figure 6-3b.

An advantage of using MACD, as shown in Figure 6-3, is that the pattem is very smooth compared with both prices and the single momentum line, and the trend of the MACD pattern is often a leading indicates of price change. The peak prices that occur on both May

15th and May 20th are followed by a sideways price pattern over the remaining part of the day; however, the MACD declines smoothly, indicating price weakness. It would be difficult to use the momentum calculstion in Figure 6-3b, because it still contains much of the erratic price movements.

Timing an Entrj

Momentum is a convenient way of identifjing a good entrj point caused by a price reversal during a trend. By choosing a much shorter time period for the momentum calculstion, for example 6 dajs, to work in conjunction with a longer trend of 30 to 50 days, the momentum indicator will show frequent opportunities within the trend. The short time period for the momentum calculstion assures you that there will be an entry opportunity within about 3 dajs of the entry signal; therefore, it becomes a practical timing tool.

Momentum as aTrend Indicator

The momentum value is a smoothing of price changes and can be very similar to a standard moving average Most applicstions use momentum as a substitute for a price trend. BY looking at the net increase in prices over the number of dajs designated by an n-day momentum indicator, intermediate fluctustions are ignored, and the pattern in price trend can be seen. The longer the apan between the observed points, the smoother the results. This is equivalent to faster and slower moving averages.

To use momentum as a trend indicator, the momentum span is selected and plotted as in Figure 6-4. A buy signal occurs whenever the value of the momentum tums from negstive to positive, and a sell signal is when the opposite occurs. If a band is used to establish a neufral position or a commitment zone, as discussed in Chapter 5, il should be drawn around the horizontal line representing the midpoint momentum value, usually zero.

Buy and sell signals that occur sooner and are likely to be stopped out more often, use a signal line created by smoothing the momentum values, in this case using a simple 3-day moving average. Once the momentum value moves above a threshold level of, for exanple, 70, a sell occurs when the momentum crosses below the signal line. The position may he stopped out when the momentum crosses above the signal line, or when momentum moves above its entry level.

To find the best choice of a momentum span, a sampling of different values could be tested for optimum performance, or a chart could be examined for some natural price cycle. Identifj the significant tops and bottoms of any bar chart and average the number of days between these cycles, or find the number of dajs that would closely approximate

FIGURE 6-4 Price momentum signals with and without a signal line.

the occurrences of these peaks and vallej-s. These natural cycles will often be the best choice of a momentum calculstion interval (Figure 6-5a).

Momentum and oscillators, however, are used just as often to identify abnormal price movements and for timing of entries and exits in conjunction with a longer-term trend.

Identifjing Extremes

An equally popular and more interesting interpretation of the momentum chart is based on an analjsis of tops and bottoms. All momentum values are bounded in both directions by the maximum move possible during the time interval represented by the apan of the momentum. The conditions at the points of high positive and negstive momentum are called overbought and oversold, respectively A market is overbought when it can no longer sustain the strength of the current trend and a downward price reaction is imminent; an oversold market is readj for an upward move. Faster momentum calculstions win reach these maximum values more often and stay there for extended periods of high upward or downward momentum. The use of a slow momentum period, however, will produce values that rarely test its limits. If the momentum sjstem uses the horizontal zero line to enter and exit trades, it is of no consequence how often the bounds are touched; once a position is entered, the high-momentum condition serves as a positive reinforcement for the trade. However, the maximum positive and negstive momentum values can be measured and used to anticipate the end of a trend. For this pu ose, momentum values that are too fast will obscure the trading signalsthe momentum index must be allowed to reach its full value.

A sjstem that takes advantage of the momentum extremes may be created by drawing two horizontal lines on the momentum graph (Figure 6-5b), above and below the zero line

FIGUEE6-5 Relstionship of momentum to prices, (a) Tops and bottoms determine momentum value, (b) Correaponding momentum.

in such a way that the tops and bottoms of the major moves are isolated. These lines may be selected visually so thai once the line is pendrated, prices reverse shortly afterward. Another selection might simply be based on a percentage of the maximum possible momentum value. A third statistical approach would be to use a multiple of the standard deviation, or some other probability distribution ftinction, so that the band is formed by the zero line plus or minus two standard deviations. That is, about 95>b of all values within the area are bounded by the two horizontal lines.

When positioning these bands, there is ahvajs a trade-off between finding more trading opportunities and entering the market too soon. This can be a complicated choice and is discussed in Chapter 22 (""Sjstem Trade-Qffs"). Once these lines have been drawn, the basic trading rules will be one of the following:

1. Aggressive. Enter a new long position when the momentum value penetrates the lower bound; enter a new short position when the value penetrates the upper bound.

2. Minor confirmation. Enter a new short position on the first day the momentum value turns down after penetrating the upper bound (the opposite for longs).

3. Major confirmation. Enter a new short position when the momentum value penetrates the upper bound coming down (the opposite for longs).

4. Timmg. Enter a new short position after the momentum value has remained above the upper bound for t dajs (the opposite for longs).

To close out a profitable position there are the following alternatives:

1. Close out long positions or cover short positions when the momentum value satisfies the entry condition for a reverse position.

2. Cover a short position when the momentum penetrates the zero line minus one standard deviation, or some target point (e.g., halfway between the zero line and the lower bound).

3- Cover a short position if the momentum recrosses the zero line, moving up after penetrating that line moving down.

A protective stop-loss order may be used to prevent giving up all profits (as in the last point) or to protect the trader from a sustained move that causes the momentum value to remain on the outside of the overbought/oversold lines.

1. Place a protective stop above or below the most extreme high or low momentum value

2. Follow a profitable move with a nonretreating stop based on fixed points or a percentage.

3. Establish zones that aa as levels of anainment fusing horizontal lines of equal spacing), and do not permit reverse penetrations once entered.

These precautions are due to both normal price variability and volatility As prices reach higher levels, increased volatility will cause momentum tops and bottoms to widen; at lower levels, they may not be active enough to penetrate the bounds. A pendration level established when coffee prices were 504 per pound and the maximum daily range was 2c would not work with coffee at $2.50 per pound and limits of 4c A reasonable modification to the momentum plot would be the use of a band or stop-loss, which is a percentage of price, or a percentage of the permissible limit move (a volatility ftinction) The tops and bottoms would remain more in-line although the risk would increase appreciably. This, however, is the intention of the oscillator.

When selecting trading rules for a countertrend technique, rid; must be the primarj concem. Using entry option 1, a short signal will occur upon penetration of the upper level, this may happen when the market is very strong, if an immediate reversal does not

occur, large open losses may accrue. One solution might be to place a fixed stop-loss at the time of each entrj. To