By Brian Bachelier, Vice President Active Trader Strategy
When it comes to validating and knowing when to act on trading signals, understanding momentum is key. This can be particularly true when it comes to overriding trading signals that come from technical analysis indicators.
Take a look at the stock chart we grabbed from the Advanced Scanner in new ScottradeELITE’s momentum scan for a Bollinger Break (Up). If you understand the basic reading of Bollinger Bands®, you would interpret a move above the upper Bollinger Band as an indication that the stock is overbought and there’s an increased probability of a pullback. However, the signal from Bollinger Bands may turn out to be a false read in cases like the one below.
The Setup
Figure 1 - Bollinger Bands® and Momentum Indicator are set to their default settings. Auto Trend Lines were set to 1 line from a pivot point with two pivot points required for a line, weak pivot points used.
For our purposes, let’s call this stock XYZ Corp. In the one-year daily chart above, we see that XYZ was in a nice steady uptrend for the first nine months of the year. The stock then proceeded to decline roughly 26% from its most recent high. That price decline ended up forming a type of the descending triangle pattern which is actually considered a bullish pattern. Based on theories prevalent in technical analysis, the upside price objective from a descending triangle pattern would require us to measure the height of the base of the triangle (its widest point). You would then add that value – an 8-point move in this case – to the value of the stock at the point where the stock price breaks out from the pattern. The momentum indicator also confirms an advance with a breakout above its prior levels.
Headwinds or Tailwinds?
Figure 2 - Sector Trends under the Research tab set to stock view.
As part of any trading plan, it’s generally a good idea to review the market, sector, and industry momentum strength to try and identify any potential headwinds or tailwinds. An ideal situation is one where you see signs of increased momentum within the sector and the industry. According to our proprietary Sector Trends momentum formula, the stock shown above is certainly seeing a positive change in momentum, but no significant changes seem visible from the market, sector, or industry perspective.
Entry and Exit Points, Your Risk and Reward
Since the break out from the declining triangle pattern happened at about $27.50 a share, pattern analysis would suggest an upside target of $35.50. With a current price of just over $31.00, this leaves an expectation of $4.50 upside potential. However, patterns can fail to predict future price action, so you may want to look at various trading strategies to form an exit plan. Potential options suggested by the chart pattern:
- Use the consolidation after the breakout as a support level for a stop-on-quote order. The low end of the trading range is roughly $28.00, so you would have a potential for $3.00 of downside risk.
- You might have noticed that the stock gapped up today and the low end of that gap at $29 would be sufficient for setting a stop-on-quote, reducing the downside risk to $2.00.
What makes for a good entry or exit point is specific to each trader. Each of us has a different level of expectation for the money we put at risk each day. Try and think through your trades before you execute one and record your experiences. It’s fully possible that setups like this one fail, but having a written record provides an opportunity to review what decisions were made and how any of them might have been flawed.
Bringing it Full Circle
The key point here is that you should really understand each indicator you use. When a rotation or trend change occurs, you expect to see indicators giving overbought or oversold signals and expect that those signals might be useful in confirming a change of the prior trend.
All indicators are mathematically driven. So in the case of Bollinger Bands®, in theory, it makes sense that 95% of the time the price would return toward the average using a 2 standard deviation setting. However, in 5% of the cases, a move above or below band is actually a signal of a change in momentum.
Read Next: 6 Tips for Using Market Momentum
What indicators do you use to identify momentum?
The analytical tools described in this article are for information purposes only and their use does not guarantee a profit. None of the information provided should be considered a recommendation or endorsement of any specific investment, tool or strategy. The choice to engage in a specific investment, tool or strategy should be based solely on your research and evaluation of risks involved, your financial circumstances and investment objectives. Securities are subject to market fluctuation and may lose value. Market volatility, volume, and system availability may impact account access and trade execution.
using more than one indicator and more than one time frame can often give a more accurate overall picture. i like bigcharts.com, advanced chart, and use bollinger bands, slow stochcastics, r.s.i.,and m.a.c.d. with the default parameters with both 1 year daily and all data either weekly or monthly, depending on how much data is available, occasionally 10 days hourly, to get a good idea of support/resistance. note that the above oscillators with the default parameters will often respond with a time sensitivity in the same order that they have been listed . when they all indicate overbought or oversold simultaneously, the prediction is more likely to be accurate. if there is a trend reversal up, you may see the bollinger bands and slow stochcastic indicate overbought, r.s.i. will be crossing 50, and m.a.c.d. coming off a low reading. i have not mentioned moving averages because they are more useful for trend following but when they cross. they can be useful to predict trend reversal as well. the example of charting given that we are commenting on seems to me as more of a support/resistance pattern.