Combining Trend Analysis with Momentum

By Sean Dillon

Momentum is an important tool in the technical analyst’s toolbox. As we learned in physics 101, momentum is defined as mass velocity, or in layman’s terms, the speed at which something is moving. As with all universal laws, technical analysts can apply this concept to stock prices to determine stocks that have strong or weak momentum, and invest in the former over the latter.

There are a variety of momentum indicators from which to choose, but my favorite has always been the Relative Strength Index (RSI). RSI is an indicator that measures momentum by comparing the strength of gains and the strength of losses over a certain time period, oscillating between 0 and 100. Stocks with strong momentum tend to achieve RSI scores above 70 while stocks with weak momentum tend to achieve scores below 30.

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In the example below we are analyzing the Materials Select Sector SPDR Fund (XLB). In the top pattern is the price chart and in the bottom panel is the 14 day RSI. The 14 day RSI, not surprisingly, uses the average gains over the last 14 days and compares them to the average losses over the last 14 days.

In analyzing the RSI, we can see that XLB had strong momentum off the February bottom as the indicator moved above 70 in both March and April, and it did not fall below 30 during the June correction. However, on the July move higher in price the indicator failed to move above 70, creating a divergence in price and momentum. Momentum was weaker as illustrated by the falling red line and is a warning signal that price may start a new move lower.