When Momentum Fails

Well, stock markets are looking like they want to confirm a bottom (more on that “soon” in a WSW posting) so it’s time to start digging in the Momentum area. But first…

Preparatory to doing ANY momentum trades, you must know what it looks like when momentum fails. IT WILL FAIL, so be ready for that day and leave when it’s time to get out, OK?

First up, Netflix has been in the news lately. They have made a big mistake in changing their pricing plan and pissing off the customer base, which was then followed by an earnings miss as customers revolted. The result was a ‘story stock’ darling turning into a ‘story stock’ horror story.

There are two charts here, with two different time scales on the Simple Moving Average stacks. Why two? First, so you can see that it doesn’t really matter all that much if it’s a 25, 50, 75 day stack or a 50, 100, 150 day stack. They both show the end of momentum fairly clearly. Use whichever numbers ‘speak to you’ more. For the faster chart, the 25 day inflects faster, but gives more ‘false starts’. For the slow chart, price clearly tracks up the stack and the plunge through is very clear, but a bit later.

Sometimes the time scale that works best on one stock is not the same as for others. (The faster things move, the faster the SMA stack needs to be to keep up, in essence). Sometimes you just need to make it easier by picking an average where price doesn’t do a ‘false plunge’ too often (based on what spooks YOU). I usually use a fast stack of 23, 46, 69 days, but that’s just because I’m more often trading the swings than following the momentum for a year…

OK, on to the charts.

NetFlix

NFLX momentum fails SMA 50 Rsi Macd DMI

NFLX momentum fails SMA 50 Rsi Macd DMI

This chart has the 50 day slow SMA stack. Prices cleanly ride the stack up, then cleanly plunge through on the failure of momentum.

MACD is above the zero line during the momentum run, then falls to negative at the failure.

DMI has clean runs of ‘blue on top’ during momentum runs, turning to ‘red on top’ on the failure.

I think it’s pretty easy to see “when momentum ends”, even without the ‘news flow’ about management stupidity.

BTW, those lines at the bottom are the SPY S&P 500 index fund, EWZ Brazil Fund, JJC Copper, and the Dow Jones Transportation Average. They had large swings during this time, so you can see how a ‘media darling’ can have gigantic gains; and losses if you buy in late and then hold after “momentum reverses”…

OK, now take a look at RSI. Notice it’s a 50 / 80 oscillator most of the run up? Then, nearing the rollover point the peaks start to trend down away from that 80 line? That’s your ‘early warning’ that the end of momentum is near. Watch for it. It comes before the actual end of the run and it is a great ‘get ready’ signal.

This next chart has a faster SMA stack. It also has the “momentum’ indicator on it (that is not exactly the same as a ‘momentum stock’…) along with the very similar Rate Of Change indicator. A bit harder to read, but you can see how the ‘mass of black’ shifts from above the line to below the line when momentum reverses.

NFLX Momentum Fails SMA 25 x 3, Mo MACD ROC with Price Channel

NFLX Momentum Fails SMA 25 x 3, Mo MACD ROC with Price Channel

With the faster SMA stack, price cuts down through the 25 day line more often (a nice ‘buy the dip’ signal most of the time) yet still tends to stop without violating the slower 75 day line. A bit better for trading those ‘ripples’.

On this chart we also have a ‘price channel’ around the price bars. It’s “stair steps up” with only the occasional step down to the bottom line during the momentum phase, but pretty cleanly converts to “stair steps down” during a collapse. So if it does a ‘stair step down’ and SMA lines are starting to cross over, well, just walk away.

So, look them over. Get to where you can see, early and clearly, ‘when momentum turns’ and simply get out then. Only if you can do that, only if you have the discipline to look at a chart every week at a minimum and preferably every day and “make that call”, ought you consider doing ‘momentum trades’. If you trade momentum stocks off the “news flow” you end up buying MCP as a “story stock” just before the collapse. NFLX as a “story stock” and not catching the management screw up.

Molycorp

This is an example of a very extreme “story stock”. News flow was driving this to very high volatility, so the chart is a bit more erratic and harder to read. Watch out for these, they can bite hard. Notice the big wobbles up and down. Nice fast day trades, but if you buy away from the SMA stack touch, it’s a long wait to make a decent sell… So buy ‘momentum stocks’ on the dips back to the SMA stack, not on the ‘news flow’ driven “story stock pops”…

Moly Corp Momentum fails RSI MACD DMI

Moly Corp Momentum fails RSI MACD DMI

RSI didn’t give much warning on this one, as the shift was from a macro economic shift to ‘China having issues’ rather than company specific. MACD does a nice job on the zero crossing. You did get a nice ‘return to the SMA stack from below’ to exit during the ‘weaving SMA lines stage’ if you had not already got out. DMI was cleanly “blue on top” during the momentum phase, then ‘muddled’ during the SMA Weave, turning “Red on top” in the plunge.

All in all, a hard trade, but workable with some care in chart reading.

OK, just for completion, we ought to look at a stock index as a ‘momentum’ play.

EWZ Brazil

Brazil was subject to some extreme shifts of emotion as elections happened and economic winds shifted. It was a ‘darling’ of the BRICS for a while, then fell out of favor. This is a longer term chart, but daily tick marks, so a bit hard to read unless you click on it and expand the size. You get to see a momentum end, plunge, return, go flat, and then fall again. You only want to own those positive momentum runs. If the chart doesn’t look like those parts, sell.

EWZ Momentum RSI MACD DMI

EWZ Momentum RSI MACD DMI

Because things were very strongly ‘news flow’ driven on major economic and political events, Brazil was very volatile. Trading it on a very fast chart would make money out of those pops and drops. Yet even just spotting the good runs and avoiding the bad ones was enough to give a very strong advantage. With MACD ‘blue on top’ and above the zero line, things are good. With DMI “blue on top” things are good. If prices touch the SMA stack then, you buy. If they plunge on through and things go ‘red on top’ just sell and wait out the plunges. For this kind of volatility, trading the MACD crossovers helps preserve gains and makes the trades better.

But what about just a few years before?

The years leading up to 2008 were a great ‘momentum run’ for Brazil. I was in EWZ far more often than I was out.

It was, in a very real sense, a ‘momentum country’ then, and while it was worth it to “step out” during the ‘red on top’ phases and buy back in on the inflections back up, the overall pattern was a great momentum story. But look at what happened in the end if you did NOT let go of that “story” and get out when the chart had MACD below zero and DMI “Red on top”:

EWZ 2004 2008

EWZ 2004 2008

So never “marry a stock”, or even a whole country. ALL Momentum ends. Just buy the good parts, and when the time comes to leave that party, well, better to leave “fashionably early” while the music is still playing than get stuck washing the dishes for dinner…

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About E.M.Smith

A technical managerial sort interested in things from Stonehenge to computer science. My present "hot buttons' are the mythology of Climate Change and ancient metrology; but things change...
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