P1: PIC/PIC c02
August 18, 2008
Multiple Time Frame Momentum Strategy
Printer: Yet to come
I use the term capital exposure to describe what many trade educators call risk. Risk is the probability of an event happening. Capital exposure is the amount of money (capital) that may be lost if a market moves against you. I have much more to say about capital exposure later in the book. Let’s begin with the concepts of trend and momentum before we even look at a chart or the dual time frame momentum strategy rules.
WHAT IS MOMENTUM? In the world of trading, there are hundreds of momentum indicators (also called oscillators). Most of these indicators use the same information, the open-high-low-close of a price bar, and represent about the same thing, the rate-of-change of price. There is nothing mysterious, magical, or unique about this. All price indicators look back over a given period, called the lookback period, crunch the price data, and compare the recent price position with the price position of the lookback period. Different indicators manipulate and display the output differently, but all price-based indicators represent about the same thing: the rate-of-change or how fast the price trend is moving. The indicator reversals represent the change in momentum—the increase or decrease in the rate-ofchange of the price trend. That is why you can use almost any price based indicator for the Multiple Time Frame Momentum Strategy you will learn in this chapter. The first and most basic concept is this: Momentum indicators do not represent price trends. Momentum indicators represent momentum trends. This should be obvious, but I can’t tell you how many new traders over the years expect a price reversal every time a momentum indicator reverses. It just doesn’t work this way, because the indicator does not represent the price trend. If it did, this book would be about three pages long because all we would have to do is reverse our trade position each time a momentum indicator makes a reversal, and we would compound money faster than rabbits on Viagra can reproduce. Unfortunately, it is not that easy. Price and momentum do not always trend together. For example, a momentum indicator may make a bearish reversal and decline while the price trend continues to advance. How can it do this? The rate-of-change of the price trend is decreasing even though price continues to advance. The bullish trend is just slowing down, so the momentum indicator is bearish even though the price trend continues to be bullish. The outcome: The price trend and momentum trend run opposite of each other. Let me repeat this basic and very important concept about momentum indicators: Momentum indicators represent momentum trends, not price trends. Never expect price to reverse when the indicator makes a reversal. Often both price and momentum reverse together, but sometimes they will diverge because the price trend is only slowing down, forcing the indicator to reverse. This point is important to clearly understand, and the vast majority of traders just don’t get it. So let me repeat it one more time: Momentum indicators represent momentum trends, not price trends. Price and momentum may not trend in the same direction. Not every momentum reversal will coincide with a price reversal.