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March 2006
This month’s Trade Secret was submitted by Charles K. Langford, vice-President, Portfolio Overlay Management, at New Providence Portfolio Management Ltd. Mr. Langford has been giving seminars and lectures on risk management of exchange-traded and over-the-counter stocks, bonds and derivative instruments since 1975. He holds an M.A. degree from McGill University and is a Fellow of the Canadian Securities Institute. He has published hundreds of articles as well as a dozen books on options strategies, technical analysis, risk management of long-term and short-term interest rates, and portfolio management. He publishes a daily bulletin on the Internet providing technical analysis of ETFs (exchange traded funds) and futures contracts. Mr. Langford’s latest book, Le chasseur de tendances boursières (The Trend Hunter), showing how to detect new price trends, was published in French in February 2006 by Les Éditions Quebecor.
Henry Ford (1863-1947), founder of the giant car maker, was a myth. A symbol of economic success, he was considered a man whose accomplishments resulted from wisdom and perseverance. One day, asked to describe the secret of his success, he replied: “Before everything else, get ready.”
This truth also applies to investing in securities. How can an investor be ready, i.e. how can he determine if the price of a stock or ETF is approaching a trough or a peak?
Technical analysis offers an extraordinary basket of tools, providing investors with what they need as long as they know how these instruments work. One very useful instrument for getting ready is the Momentum (or Mom). It is so old that it surely existed at the time of Henry Ford. Indeed, the Mom is the “father” of indicators, a true classic. For example, Wilder’s RSI ( Relative Strength Index), now very popular, is only a variant of the Mom but “invented” a few decades later. The reader will find the Mom on the platforms of Disnat and DisnatDirect or on the Internet (for example, at www.bigcharts.com or www.stockcharts.com).
The Mom formula is very simple: it is the difference between the closing price of today’s session and that of a preceding session. For example, if the XIU (the exchange traded fund that reflects the behaviour of 60 Canadian blue chip stocks) ends today at $66.75, and if the closing 12 sessions ago (approximately two-and-a-half weeks ago) was $66.25, the difference is +$0.50. This value is positive because the current closing price is higher than the preceding one. If the previous close had been $67.00 (implying that the current close is lower), the difference would have been negative: –$0.25. At each new session, we subtract the closing price of 12 sessions ago from the current close. The Mom is thus a moving difference between two prices, advancing by a fixed interval of time (or frequency).
The frequency of 12 in these examples is not obligatory. There exists software that offers frequencies of 12 or 20; other software leaves the choice to investors. As a rule of thumb, a frequency exceeding 20 makes the Mom less sensitive and thus not very useful, whereas at less than 12 the Mom is oversensitive.
Figure 1 gives an example of a Mom-12 applied to the XIU. The ETF bar chart appears above and the Mom below.
Figure 1 – A daily bar chart of the XIU (an exchange traded fund) and a 12-period Mom.
The Mom is shown by means of a horizontal line (0), a positive scale (from 0 to 5) and a negative scale (from 0 to –5). Originating from the zero line are daily vertical bars that indicate positive (above the horizontal line) or negative (below the same line) differences.
The simplicity of the Mom is as disarming as its capacity for getting ready is extraordinary. The Mom cannot tell you when to buy or sell, but it can show that a current trend, despite apparent strength, is tired or spasmodic. A true sign of when to buy or sell will be provided a little later by other tools such as the two moving averages method or graphic configurations. Reading the Mom is simple: it is based on the visual divergence between Mom trends and price trends. When they go in divergent directions, this anticipates a change in the current trend. Examples are easy to find.
In Figure 1 we easily observe at least three divergences, each one anticipating a change in the direction of prices.
In September the direction of the Mom is downward, whereas the trend of the XIU is still rising. The price falls significantly after its last peak, near the end of September.
In October, whereas the price is still falling, the Mom is already trending upward, anticipating a significant rise that will last until February.
In February the price reaches another peak, whereas the Mom is already pointing downward, anticipating the end of a long trend.
Figure 2 offers another series of examples. The stock in question is Bombardier. The graph reflects 12 months of prices instead of six (as in the Figure 1). The abundance of data in a small space makes the vertical bars of the Mom look like dark zones.
Figure 2 – A daily bar chart of Bombardier with a 12-period Mom
In Figure 2 we see at least three divergences between the stock price and the Mom.
In August-September, while the price moves from an initial peak to a new one, the Mom goes the opposite way, anticipating a decline.
In October-November, the price is still headed downward; but the Mom is clearly pointing in the opposite direction, thus alerting us to the imminent end of the trend.
In December-January, the price advances, but the Mom is already showing that the upward movement is running out of steam and a decline is approaching.
The Mom sometimes remains silent: it shows little divergence despite a coming change in price trends. But when the divergence is clearly visible the probability of an imminent change in the trend is nearly absolute.
Sometimes the Mom shows a divergence but the new direction in prices is slow to appear. For this reason the Mom is a tool to be used only for getting ready and staying alert, not an invitation to buy or sell at the moment of divergence.
Returning to Henry Ford, he once said: “If money is your hope for independence, you will never have it. The only real security that a man will have in this world is a reserve of knowledge, experience, and ability.”
The Mom is a good place to start.
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