One of the Most Reliable Trading Tools Is Signaling Caution

An image of a stock chart with a coin on top of it Credit: Shutterstock photo

As a trader, one of your most important tools is also the simplest. A basic momentum indicator will provide you with several clues about the market's intention. This week, we look at developments in some of the most important global stock indices, and we use that as an opportunity to draw out examples of how a momentum study can be useful. You will discover that similar signals are showing up in indices from around the world.

Starting in the US, the Dow Jones Industrial Average (INDEXDJX:.DJI) is one of the four indices we watch most closely. On a weekly time frame, the index has tested trendline support twice this year and has rebounded strongly both times. The impressive rally this week even brought the Dow up to the 61.8% retrace from its summer high.

However, momentum tells a different story. Whereas price surged in the early part of the summer, momentum as measured by the two indicators at the bottom of the chart is lagging behind price movement. In addition, the topmost indicator (the Adaptive CCI) approached the important zero-line as of last week's close.

There are several flavors of momentum indicators, but at their essence, all off them compare the rate of recent price change against the rate during some earlier period. Of the two shown on the Dow chart, the lower one (the MACD) has the advantages of being very simple and fairly smooth. It continually measures the distance between a fast-moving average of price and a slower-moving average, and it can be found in almost any charting package. If you are working on a time frame that isn't too noisy, you will find that using five bars for the fast average and 34 bars for the slow average produces excellent signals.

The uppermost indicator is a modified version of the Commodity Channel Index. We prefer it because it has a better record of producing good signals near the zero-line compared to similar indicators. The Adaptive CCI also provides an advantage by changing its output slightly based on cycles it detects in the market. The version shown here is part of the Wave59 trading platform.

It you had traded the Dow in recent years based solely on weekly momentum signals, you'd probably be booking your next vacation today. You would have taken a long position late in 2011 and either held steady or jumped out at momentum peaks and back in at tests of the zero-line. However, the negative divergence that's showing up now most likely would have you exiting the trade.

The Euro Stoxx 50 Index (NYSEARCA:FEZ) also is displaying higher highs with this week's rally, along with lagging momentum. Our Elliott Wave count for that index suggests a possible ending pattern developing, although it might not yet be complete. (Additional price targets and resistance levels on the monthly timeframe for the Euro Stoxx 50 and also the German DAX can be found in the extended version of this article posted on our website .)

Momentum on the Global Dow Index (INDEXDJX:.GDOW) is showing more subtle signs of exhaustion. Although there is not yet any clear divergence between momentum and price, momentum has twice tested the zero-line this summer. We are watching for the reaction to the resistance provided by the Schiff channel shown on the chart.

The bottom line is, we are finding these kinds of divergences all over. For example, you can see them in the Nasdaq-100 (INDEXNASDAQ:NDX), the S&P 500 (INDEXSP:.INX), and the S&P 100 (INDEXSP:SP100) indices. One of the most basic and reliable charting tools is trying to tell us something.

This article originally appeared on Trading on the Mark .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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