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Assessing
the relative levels of greed and fear in the market at a given point in time
is an effective way of timing the market. This article outlines the 6 most
popular momentum indicators and concludes that trading gold using just 3 of
the indicators would have generated an annual return of 39.6% compared to the
YTD buy-and-hold return of only about 13%! Let me explain how, why and
where they should be used and examine their specific application relative to
the price movements in gold and the HUI.
Securities ebb and flow,
surge and retreat, and such action is measured by oscillators which are
powerful leading indicators of the security’s immediate direction and
its speed and are most useful, and issue the most valid trading signals, when
their readings diverge from prices.
Bullish divergences occur when prices fall to a new low while an
oscillator fails to reach a new low. This situation demonstrates that bears
are losing power, and that the bulls are ready to control the market for the
stock or index again and such divergence often marks the end of a downtrend.
Bearish divergences signify up-trends, when prices rally to a new
high while the oscillator refuses to reach a new peak. In this situation,
bulls are losing their grip on the security, prices are rising only as a
result of inertia, and the bears are ready to take control again.
There are a number of
different approaches to this concept, as follows:
1.
Stochastic Oscillator
(SO)
- is a momentum indicator that compares a security’s closing price to
its price range over a given time.
The theory behind this
indicator is that in an upward-trending market, prices tend to close near
their high, and during a downward-trending market, prices tend to close near
their low.
There are two components
to the SO: the %K which is the main line indicating the number of time
periods (usually 14), and the %D which is a three-period moving average of
the %K. Buy/sell signals occur when the %K crosses above/below the %D.
A %K result of 70 (or
30), for example, is interpreted to mean that the price of the security
closed above 70% (or below 30%) of all prior closing prices that have
occurred over the past 14 days and assumes that the security’s price
will trade at the top (or at the bottom) of the range in a major uptrend (or
downtrend).
A move above 80 suggests
that the security is overbought and therefore should be sold while a move
below 20 suggests that the stock or index is oversold and, as such, is a
buying signal.
The SO, which ignores
market jolts, is an ideal companion to the MACD to provide an enhanced and
more effective trading experience. Using the two together gives traders an opportunity to hold out for a better entry point on an
up-trending security or to be more sure that any down-trend is truly
reversing itself when bottom-fishing for long-term holds.
However, on the downside,
because the stock or index generally takes a longer time to line up in the
best buying position, the actual trading of the security occurs less
frequently, so you may need a larger basket of stocks to watch.
2.
Relative Strength Index
(RSI)
- is a momentum indicator that compares the magnitude of recent gains in
price to recent losses in an attempt to determine overbought and oversold
conditions of a security.
The RSI, on a scale of
0-100, indicates that a stock is overbought when it is over 70 and oversold
when it is below 30.
Because large surges and
drops in the price of a security will create false buy or sell signals the
RSI works best when it is used in conjunction with short-term moving average
crossovers such as the Stochastic Oscillator to confirm a directional shift.
3.
StochRSI
- is created by applying the Stochastic Oscillator to the Relative Strength
Index values rather than standard price data thereby giving the trader a
better idea of whether the current RSI value is overbought or oversold
– a measure that becomes specifically useful when the RSI value is
confined between its signal levels of 30 and 70.
 
If you had used the above
3 indicators as your guide to buy and sell physical gold throughout 2011 you
would have:
- bought gold on Feb. 1st at approx. $1,325
and sold out on April 21st just prior to the Good Friday/Easter long
weekend at approx. $1,500 for a profit of $175 or 13%
- bought back in at approx. $1,500 on July 5th
after the long weekend and sold out at $1,850 or so on September 6th
immediately after the Labor/Labour Day long
weekend for a tidy profit of approx. $350 or 23%
The above 3 indicators do
not yet suggest that you get back into gold – yet. Nevertheless, trading
gold using the above 3 indicators would have generated a profit of $525 for
an annual return on your gold investment of 39.6% over just 132 days –
compared to a YTD buy-and-hold return of only about 13%! (Perhaps I
should have titled this article “How to Triple Your Returns in Gold“.)
Now let’s look at a
chart for the same time period using the TRIX, CCI and ROC momentum indicators
and see what they reveal:
3.
TRIX
- is a momentum indicator that displays the percent rate-of-change of a
triple exponentially smoothed moving average of a security’s closing
price.
TRIX is designed to
filter out security movements that are insignificant to the larger trend of
the security. The user selects a number of periods (such as 15) with which to
create the moving average, and those cycles that are shorter than that are
filtered out.
TRIX is also a leading
indicator and can be used to anticipate turning points in a trend through its
divergence with the security’s price.
4.
Commodity
Channel Index (CCI
- is an oscillator which quantifies the relationship between the
security’s price, a moving average of the security’s price, and
normal deviations from that average to determine when a security has been
overbought or oversold.
The CCI, when used in
conjunction with other oscillators, can be a valuable tool to identify
potential peaks and valleys in the security’s price, and thus provide
investors with reasonable evidence to estimate changes in the direction of
price movement of the security.
5.
Price
Rate of Change (ROC)
- measures the percentage rate of change, indicating the strength of the
momentum, between the most recent price and the price over “x”
periods (the narrower the better) thereby identifying bullish or bearish
divergences.
The ROC is able to
forecasts sooner than almost any other indicator an upcoming reversal of a
trend and whether or not a security’s price action is created by those
over-buying or over-selling it. A number other than zero can be used to
indicate an increase in upward momentum and a number less than zero to
indicate an increase in selling pressure.
An analysis of the
movement in the price of gold in 2011 using the TRIX, CCI and ROC indicators,
however, would not have been nearly as effective in identifying entry and
exit points to the extent that the STO, RSI and StochRSI
indicators do.
Precious Metals Stocks
and Warrants
A look at the 1 year
chart for the HUI Index below using the Full STO, RSI and StochRSI
shows that these momentum indicators are also very useful in capturing points
in time to buy and sell large cap gold and silver stocks and their associated
warrants where available. (For information regarding long-term warrants
associated with such stocks please read Gold and Silver Warrants: an Insider’s Insights)
If you had used the above
3 indicators as your guide as to when to buy and sell a basket of large-cap
gold and silver mining and royalty stream company stocks throughout 2011 you
would have:
- bought in around Jan. 21st and sold out
around April 8th for a return of approx. 13%
- bought back in the week of May15th and sold
out around Sept. 8th for a return of approx. 14%
As with gold the above 3
indicators do not yet suggest that you get back into the gold and silver
mining stocks - yet. Nevertheless, trading such stocks using the above 3
indicators, and the HUI as a proxy, would have generated an annual return on
your investment of approx. 27% over just 190 days – compared to a YTD
buy-and-hold return of about -11% !
So there you have it
– an extensive and in-depth assessment of how to evaluate the momentum
impacting your securities of interest. The next time you analyze an asset you
will be in a better position to determine which direction the asset is
trending and what the appropriate dates are throughout the year to buy and
sell the security. In the next few weeks I will be posting further articles
on trend indicators and market strength and volatility indicators to better
enable you to time the market over the course of 2012 to avoid losses and
maximize returns.
Lorimer Wilson (follow
via FACEBOOK
and/or TWITTER ) is
editor of www.munKNEE.com (Your Key to Making
Money!) and www.FinancialArticleSummariesToday.com (A
site for sore eyes and inquisitive minds) and publisher of a daily FREE Financial Intelligence Report which
can be subscribed to here.
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