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Larry’s note: Welcome to Trading with Larry Benedict, the brand new free daily eletter, designed and written to help you make sense of today’s markets. I’m glad you can join us. My name is Larry Benedict. I’ve been trading the markets for over 30 years. I got my start in 1984, working in the Chicago Board Options Exchange. From there, I moved on to manage my own $800 million hedge fund, where I had 20 profitable years in a row. But these days, rather than just trading for billionaires, I spend a large part of my time helping regular investors make money from the markets. My goal with these essays is to give you insight on the most interesting areas of the market for traders right now. Let’s get right into it… |
Without a doubt, one of the most important things in life is momentum.
Perhaps you’ve felt it yourself with your career, playing sports, or in your personal life. It’s like a wave of energy pushing you forward from one positive moment or achievement to the next.
Well, the same thing happens with the markets – sometimes momentum just seems to push a stock higher.
If you’ve followed the markets for a while, you may have already seen that for yourself. You see a stock climb day after day and think, “surely that just can’t keep going up.”
Yet, up it goes… sometimes even when the rest of the market is falling.
For a trader, getting into a stock with growing momentum can be one of the best setups for a profitable trade. Catch on to a couple of them and you’ll really see your trading account grow.
The question is, though, how do you pick a stock with momentum?
Well, part of that lies with the price chart. If you can see that a stock price is rising – and gaining at a bigger rate each day – that can be a sign of growing momentum.
However, it’s not always easy to gauge…
That’s where technical indicators can help.
One of the momentum indicators that I use a lot is the Relative Strength Index (RSI). If you’ve been following along with my essays, you’re probably familiar with the RSI.
The RSI calculates the number of up days versus down days of a stock over the preceding 14 days. It then uses the magnitude of those gains (or losses) to determine the stock’s overall momentum.
If a stock is going up, and the size of those up moves are increasing, then the RSI will go up. And vice versa.
A falling stock, where the price drops by a bigger amount each day, will cause the RSI to fall.
The RSI is represented as a line on a chart between zero and 100.
Now, let’s pull up a chart of the SPDR Gold Trust ETF (GLD) so you can see what I mean…
SPDR Gold Trust ETF (GLD) Price Chart
Source: eSignal
The top half of the chart shows the price history of GLD, and below that is the RSI (blue line).
At first glance it all seems kind of busy. However, you should be able to see a clear correlation between the stock price and the RSI.
When the RSI is going up – meaning momentum is increasing – the GLD share price is going up too. And vice versa.
For example, you can see that by looking at “A” to “B” on the RSI.
But where the RSI becomes even more useful is in showing declining momentum.
Most of us have bought into a rising stock just before it runs out of steam and turns down. It can be really frustrating.
But this is where the RSI can help. The RSI shows when there’s a likely change in momentum, and that can often mean a change in the stock’s direction.
On the RSI are two grey horizontal lines – the upper line at 70, and the lower line at 30.
When the RSI goes below the lower grey line, that means the stock is likely oversold and could turn back higher.
In other words, selling momentum is slowing down.
And, when the RSI goes above the upper grey line, that means the stock is likely overbought and could be headed for a pullback. In this case, the buying momentum is waning.
Let’s take another look at the chart…
SPDR Gold Trust ETF (GLD) Price Chart
Source: eSignal
This information helps you in two ways…
First, you might hold off buying a stock if the RSI is showing it to be overbought – just like “B” on the chart. This helps reduce the chance of buying right before a pullback. (Note: GLD fell right after hitting B).
And second, it can be a trigger to enter a trade that goes counter to the previous direction.
For example, if a stock price is falling and the RSI shows it to be oversold, you might use it as a signal to go long (and buy) – just like at “A.”
To be clear, the RSI is not a perfect tool. When it comes to the markets, nothing works 100% of the time.
However, the RSI certainly helps gauge one of the most important things that is the true energy of the market – momentum.
And because of that, it can really help put the odds in your favor before placing your trades.
Regards,
Larry Benedict
Editor, Trading With Larry Benedict
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