How to trade momentum Part 3

Momentum as ratio of two moving averages

Most traders have heard of "Golden cross" and "Death cross".

Golden cross occurs when 50 day moving average crosses the 200 day moving average and it indicates major trend change.

The conventional wisdom is to buy all pullback after the cross.

The Death cross is reverse of this, which happens when 50 day moving average crosses the 200 day moving average. It is suppose to signal a start of bearish trend.

The death cross is an example of using a ratio of moving average to create momentum signal.

A ratio of moving average can be used as a momentum indicator.

In Golden cross and Death cross it is used on single instrument, however better way to use the ratio of moving average is to use is to rank stocks.

To do that you have to calculate a ratio of moving average.

Momentum= Moving average of 10 days/ Moving Average of 50 days

In Telechart we can write a scan like this to do this:
Momentum= AvgC10/AvgC50

If we sort all stocks by this ratio and select top 10% stocks, it will give us stocks with momentum.

Reducing the noise

This kind of method for calculating momentum reduces the noise and reduces the lag . Earlier methods of calculating ROC suffer from lag effect. So using ratio of moving average is a way to reduce the lag.

The periods chosen for moving average in above calculation is again a function of your trading frequency. A ratio of shorter moving average periods will identify shorter term trends faster.

While a ratio of 50 day moving average to 130 days or 260 days will identify longer term trends.

When using ratio of moving average to calculate momentum you can back weight or front weight them depending on your objective.

Once this ratio is calculated you sort the stock universe with it and take the top 10% stock.

Momentum as a ratio of price to moving average

Or another way to do this is to use a ratio of price to moving average

Momentum 6 month= Price/ 6 month moving average of price

What time frame to use for calculating momentum depends on your trading time frame. If you are short term momentum trader you might want to use 42 days momentum. If you are swing trader a 6 month momentum is good. If you are long term trader a one year momentum is what you might look at.

Using such a approach you can identify top 5% stocks by momentum. Once you have a momentum ranked stocks, you can use breakout or pullbacks to trade them.

To further improve your profit while using momentum method, you can use quality of momentum indicators to further narrow the stock selected using momentum ranking.

In next post we will look at what is quality of momentum.

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