Why Popular Momentum Indicators Don’t Work
Traders often turn to momentum indicators to understand the market action. Some traders use these indicators to try to get ahead of the market. They believe momentum leads price. It’s important to question assumptions and this one deserves to be examined.
Momentum indicators are various tools traders use to determine how strong a trend is.
Is Strength in Limited Supply?
Usually, traders interpret momentum indicators assuming a stock only has so much strength. They believe the indicators show periods when the stock is either overbought or oversold and these conditions are times to act.
When a stock is said to be “overbought” traders are assuming that the price moved too far, too fast. The indicators are designed to identify these price moves by applying simple calculations to prices.
There are dozens, if not hundreds, of momentum indicators. Almost all use the most basic math operations of addition, subtraction, multiplication and division. Often, they add factors to limit the range of the values so that there are clear limits.
Overbought stocks ae near the upper limit of most calculations. Traders argue that the value of the indicator is high and since it can’t go much higher, the upside is limited so the stock is overbought, and it could be best to avoid entries at that level.
In a similar way, oversold momentum indicators are at lower bound of the calculation. Again, the argument is that since the momentum indicator can’t go much lower, the stock is oversold and is due for a rally to higher prices.
The basic argument, for both overbought and oversold extremes, seems to be that there is a limit to how fast or how far prices can move. While market prices are bounded at zero on the downside, there is no limit on how fast they can move to that level. On the upside, there is no limit to price or strength.
The argument is often anthropomorphized. In this case, the trader argues is like a runner who has sprinted for an extended period of time. The amount of energy the runner has is limited and a sprint, they will eventually slow down. The longer the sprint lasts, the more likely a slowdown is.
So, a stock that sprints, delivering a quick and relatively large gain, is going to run out of energy under this argument. But the stock is not a runner and strength, to the upside or downside, is not limited by any physical factor.
A Practical Example of How Momentum Indicators Fail
Tesla offers an example of how momentum indicators fail to work as expected. The chart below shows the stock’s price with the relative strength index (RSI) at the bottom. Horizontal lines show the traditional overbought and oversold levels.
Source: Optuma [1]
RSI was “developed by J. Welles Wilder, the Relative Strength Index (RSI) is a momentum oscillator that measures the speed and change of price movements. RSI oscillates between zero and 100.
According to Wilder, RSI is considered overbought when above 70 and oversold when below 30. Signals can also be generated by looking for divergences, failure swings and centerline crossovers. RSI can also be used to identify the general trend.
RSI is an extremely popular momentum indicator that has been featured in a number of articles, interviews and books over the years.” [2]
The exact formula is a moving average of the following calculation:
Source: Investopedia [3]
There is no reason to expect this formula to find the limits of a stock’s potential gains or declines. This is simply a formula to bound the price action within a range that shows whether the recent price trend has been up or down.
Since the RSI is showing the trend, it is logical to expect high readings during the strongest uptrends, as the chart Tesla shows. In other words, there is nothing extremely useful in the calculation of popular momentum indicators like RSI.
There is good news. While popular momentum indicators will not work as expected by many traders, there are tools that do work consistently enough that it’s possible to beat the market,
Regards,
Editor, Peak Velocity Trader
Sources:
[1]: Optuma – https://www.optuma.com/research/ [2]: StockCharts.com – https://school.stockcharts.com/doku.php?id=technical_indicators:relative_strength_index_rsi [3]: Investopedia — https://www.investopedia.com/terms/r/rsi.asp
After spending nearly 20 years developing pattern recognition software for the United States Air Force, I retired from my military career in 2005. My plan was to utilize the same pattern recognition principals I used in the military and apply them to the largest and most lucrative market in the world: the stock market.
