Outside the Box
Markets must continuously digest new information. Cyclic impulses of stability and instability gather force through the pulse of this future discount mechanism. Each small event shocks the common knowledge, building a dynamic friction that dissipates through volatility-driven price movement.

In its purest form, volatility generates negative feedback as price swings randomly back and forth. However, if focused into a single direction, positive feedback awakens and generates momentum into strong price trending. Traders' recognition of these active-passive states will likely determine their ultimate success in market speculation.

Neophytes fall quickly under the spell of fast-moving markets. However, momentum is far more difficult to trade than most participants admit. When an emotional crowd ignites sharp price movement, greed clouds risk awareness. The anxious trader then chases positions just behind the big volume, where odds of a reversal quickly increase.

Obviously, the majority seek their profit through momentum. But, most ultimately fail as this wicked beast devours equity. Those who survive commit themselves to mastering the diverse skills needed to play this dangerous game.

As traders gain experience, fresh dangers block the road to success. The swing of negative feedback triggers many false alarms while real entry signals, streaming from multiple sources, remain unnoticed. In the confusion, profitable trades are missed completely or entered just as the trend dies.

Either way, bad choices consume inexperienced trading dollars and the markets tally more losers.

Like magnetic fields, polar forces drive market conditions. Alternating cycles of activity and inactivity continuously fuel the dynamics of price movement. Traders must recognize current axis conditions before executing positions.

Winning
Momentum trading can be mastered. Three disciplines will break destructive habits and reprogram trading for success:

	Abandon the adrenaline rush. Forget the excitement. Profit is dependent on detached and disciplined execution.
	Learn the numbers. The nature of price movement must be ingrained deeply enough to allow spontaneous decision-making during the trading day.
	Cross-verify. Objective measurements must filter unconscious bias.

Studying supply and demand on a scrolling ticker or NASDAQ Market Depth display provides a solid first step for understanding the inner workings of rapid price movement. Combining this with an understanding of time-of-day tendencies strengthens awareness of profit and danger zones. And, understanding all the players proffers a needed edge on the competition.

But, the study of technical analysis uncovers greater secrets as insider deception and herd emotions are exposed. Properly applied, patterns and indicators reduce the false entries associated with failure. And, they invoke natural risk management. Technical analysis teaches traders when to painlessly exit momentum positions and move on to the next opportunity.

Action-Reaction Cycle

Prices rarely move in a straight line. As shocks destabilize a market, a counter-force emerges to restrain price back toward its stable state. After each forward impulse, a backward reaction follows. Burning the fuel of the crowd's money, markets seek equilibrium before proceeding with the next impulse.

Traders fail to consider this phenomenon when they enter their momentum trades. Simply put, both action and reaction must be considered in developing appropriate entry-exit points. This requires more complex planning than most anticipate. Successful strategies often demand execution opposite to the natural tendencies of the trader:

	Entry on counter-trend reaction and exit on accelerating thrust
	Entry on accelerating thrust and exit on subsequent reaction

Exit strategy can confuse trader logic more than entry. Effective risk management may require reversing the entry process entirely:

	Exit on further reaction when counter-trend entry fails
	Exit on accelerating impulse when thrust entry succeeds

Choosing the wrong action-reaction trigger will produce frustrating results. Every trader knows the pain of making a low-risk entry, riding a profitable trend, then losing everything on a subsequent reaction. This experience can be avoided using technical analysis to identify momentum signposts and locate natural escape routes.

Identifying Momentum
Well chosen technical analysis tools signal awakening momentum and track subtle changes in strength and duration. The power to identify these transforming conditions just prior to significant price movement is the key to profitable entry. All momentum study falls into one of two broad categories:

	Trend-following indicators gaze into the rear view mirror and average price over defined time series. They are most valuable early in a trend for identifying momentum.
	Trend-leading oscillators measure developing range and movement from price bar to price bar. They provide valuable information late in a trend by identifying turning points.

Effective analysis must investigate the nature of momentum change. Physics teaches that an object in motion tends to remain in motion. Profitable entry-exit will capitalize on this universal tendency. With most indicators, this requires combining snapshots of different period lengths in order to measure momentum acceleration-deceleration.

Three types of technical tools provide complete resources needed to accomplish these complex tasks:

Line Tools visually illustrate rate of change and action-reaction points:

Trendlines Trendlines display "average momentum". While a line drawn under any two lows has limited value, the addition of a third low creates order and a prediction point for future reversals. Combined with other chart features, trendlines uncover dynamic momentum information.
Price Channels Channels predict order with only two distinct trend lows. But, these must be matched by two corresponding highs of the same slope. While logic suggests that these formations rarely occur, the opposite is true. They are easier to locate than clean trendlines.
Arcs Rounding formations are difficult to quantify. The evolving slope may not maintain a constant rate of change. This reduces its effectiveness for prediction. Use arcs as visual tools to estimate rounding reversal bottoms and tops.
Fibonacci Ratios One of the most powerful tools in technical analysis, Fibonacci remains poorly understood. This "proportional force of nature" measures retracement and testing of trend impulses. For moves to remain intact, the 62% level must provide support.

Averaging Tools combine and smooth data sets into directional and acceleration forecasts:

Moving Average Crossovers Simple crossovers mark key shifts in momentum. They form the foundation of many complex trading strategies. But, watch out. This method has severe limitations in sideways markets. During negative feedback, moving averages will emit continuous false signals.
Averaging Rainbows Use of five or more color-coded moving averages displays continuous data on evolving momentum change. In addition to targeting price strength within the rainbow bands, the lines themselves draw complex patterns with superb predictive capacity.
Moving Average Convergence-Divergence (MACD) Gerald Appel's classic moving average interaction tool found new power when expressed as a histogram. Momentum changes accurately track the oscillating slopes. Create profitable entry-exit rules with this rewarding tool.

Strength Tools measure rates of price and range ascent-descent over different time frames:

Rate of Change Directional price movement often hides within the twists and turns of price bars. Rate of change indicators filter visual data into actual price progression. ROC lines develop their own support / resistance, trendlines and patterns. Key pattern breaks in advance of price can trigger important convergence-divergence signals.
Relative Strength Index Don't trade without this important tool. RSI measures the "quality" of price movement by comparing UP days with DOWN ones. Like ROC, RSI creates patterns that respond more quickly than price change. Use overbought and oversold levels to close positions and prepare reversal strategies.
Stochastics Stochastics accurately measure short-term shifts in price momentum. But, once this indicator pierces the extremes of its wide bands, useful information ceases. As trend takes over, it wobbles randomly until conditions change. As lines move back into the center zone, measure strength through double top/bottom formations.
Bar Range Analysis Short-term traders should closely examine small price bar formations. Narrow and wide range bars signal measurable change within the crowd and impending price movement. One classic pattern is NR7, the narrowest range bar of the last 7. These predict breakouts that can be safely traded in the direction of the first impulse.

Trendlines
Trendlines join three or more reaction lows or highs into a straight line. This core element of technical analysis has many applications beyond its well-known uses. Standing alone though, trendlines contain limited information regarding momentum shifts.

The indicator plots average momentum for the trend being studied and nothing else. The rate of price change up or down the line always remains constant. Trendlines will provide significant momentum change feedback when compared with other chart data. As constant ROC indicators, these straight lines will measure convergence-divergence against any other price inputs.

Three common chart features will measure momentum change when combined with trendlines:

	Other trendline(s)
	Moving averages
	Price bars or candlesticks

When one or more of these elements accelerates away from the studied line, momentum is increasing as it diverges. Conversely, as these indicators roll over to point back "home", signals flash converging deceleration. Combining all of these features into a single momentum system will produce powerful trading signals.

Moving Averages
Moving averages contain more immediate feedback on momentum change than trendlines but are burdened by one severe limitation. Their computation forces useful data to lag current events. By the time a simple 20-bar average curves upward to reflect accelerating price, the move has already matured and may even be over. While exponential calculations (EMAs) and other smoothing adjustments speed up signals, action bells ring way too late for most momentum entries.

Using multiple moving averages overcomes this time drawback and provides timely feedback on momentum change. The simplest tool for this study is the Moving Average Crossover. Two averages are chosen based on different time frames and their convergence is tracked. Signals are generated when the short average crosses above or below the longer one. The challenge with crossovers is finding the time sequence that elicits the most profitable information about the studied market. Also, filters must be built to ignore crossovers in choppy conditions when moving averages give false signals.

An effective technique for studying momentum change is the MACD Histogram, popularized by Dr. Alexander Elder in his book Trading for a Living. Using 12- and 26-period moving averages smoothed by 9 periods, MACD creates a visual momentum ladder. As MACD rises, momentum increases. A zero line pinpoints the center balance zone. Positive acceleration flags as columns thrust above this point. Likewise, down steps below the line signal negative acceleration.

Moving Average Rainbows provide multi-time frame, multi-dimensional views of shifting momentum. Rainbows combine 5 to 8 averages, color-coded by the user's software program. Identifiable patterns develop between the averages, allowing for sophisticated analysis of impending acceleration and deceleration. Like spreading fingers, rainbow averages respond incrementally to advancing trends and provide targeted entry-exit points.

Strength Indicators
Analysis of a closing bar's contribution to recent price action creates a variety of strength indicators. These important tools range from simple comparisons with prior values to complex pattern analysis based on expansion and contraction of high-low bar lengths. Their common theme identifies the momentum pulse in the relative strength of closing price. While endless techniques accomplish this same task, several contain all the horsepower needed to beat the momentum monster.

Price Rate of Change offers an elementary computation for tracking momentum. Price bar patterns often hide developing directional movement. ROC compares current price with the value x periods ago and plots it below the bar chart on a line graph. As momentum escalates, ROC often curves upward ahead of a breakout. And, this versatile indicator works just as well signaling impending breakdowns and plunges.

Stochastics and RSI are well known for targeting overbought-oversold zones in constricted ranges. These popular oscillators also have tremendous value in charting momentum. Plotting their values on a chart reveals pattern characteristics similar to price bar ascent and descent.

These tools differ from price due to the extreme zones they cannot pass. In theory, price can go upward to infinity. Oscillators can go no further than 0% or 100% before turning back. But, as their directional movement follows price swings, patterns of acceleration-deceleration quickly reveal themselves.

Futures markets have used range bar analysis for years. A classic on the subject, Toby Crabel's Day Trading with Short Term Price Patterns and Opening Range Breakouts, investigates how expanding candle and bar patterns characterize momentum in many commodities and indices. The emotional crowd provides fuel as bar range stretches in the direction of the prevailing trend. Finally, a climax bar prints a sharp reversal under surging volume.

Computation indicators (such as stochastics) measure bar range indirectly. By going straight to the bars themselves, visual analysis yields profitable short-term prediction. However, not all markets can be accurately examined through range changes. Low volume stocks, for example, carry high spreads that will distort signals. Limit bar analysis to highly liquid markets with low spreads and high average daily movement.

The Momentum Pulse
Momentum generates force as increasing volatility resolves itself into directional movement. This dynamic trending state invokes a measurable shift from negative to positive feedback. While subsequent thrusts may appear chaotic, price movement contains many cyclical features. Pulses will often be proportional in time duration and length. This tendency allows traders to calculate reward:risk through measured move analysis. As an added benefit, these expected reversal points can also be watched for profitable swing entries.

Markets inhale and exhale. Each burst of market excitement alternates with extended periods of relative inactivity. Prices trend only 10% to 20% of the time. The balance is spent absorbing instability created from a momentum thrust. The interface between the end of an inactive period and the start of the next surge often hosts a "quiet" neutral point. Paradoxically, this Empty Zone will ignite well-tuned entry signals.

Prior to beginning each new breath, the body experiences a moment of silence as the last exhalation completes. The markets regenerate momentum in a similar manner. The Empty Zone emerges as the return to stability concludes. Because instability alone will change that condition, volatility then sparks a new action cycle.

Cross-Verification
Momentum change indicators work best when combined with other technical tools. This process of cross-verification searches for repeated confirmation of any signal through other methods of technical analysis. But, watch out. Many indicators are built on top of better-known calculations. Accidentally using one of these derivative measurements carries substantial risk. It will automatically confirm your findings just by recalculating a tool already used and give false confidence to the trade.

Verify technical conditions using dissimilar forms of analysis. For example, after seeing momentum surge on stochastics, try duplicating that observation using a line tool. Or, when multiple moving averages suggest an impending thrust, analyze the recent short-term price bars to locate narrow-range days.

Fibonacci ratios offer the most powerful form of cross-verification in all of technical analysis. Price impulses faithfully retrace similar percentages of a completed move before finally reversing or continuing the prevailing trend. Examining the price action near these support / resistance zones will identify significant bounce reversal opportunities when other indicators offer support.

Using Fibonacci requires only a calculator or Fib Line Grid (available with most charting analysis software). Hidden support / resistance exist at 38, 50 and 62% of the prior trend. Price will often bounce like a pool ball back and forth across this marvel of mathematics.

Exit
Traders fail when they don't manage their losses. The lure of the big gain disables unbiased evaluation. Danger increases significantly when trading in a high momentum environment. The wide swings ensure price will move through a 10 to 40% range in a very short time frame. While position traders can consider well-placed stops, many short-term and day trading vehicles don't allow limit management.

Positions should never be entered without anticipating an appropriate escape route.
Winning is a tough game. Each trader must compete against all other participants and take their money. And, exchange rules always favor market insiders highly skilled in shaking small players out of their positions. To find an edge, remote traders must replace mechanical self-control (stops) with strong mental discipline.

Use technical analysis and drill key price swing numbers of favored markets into memory. Target an acceptable tick loss average. If the average tick gain isn't larger, the winning percentage will need to be well above 70% to turn acceptable profits. Improve results by getting your loss average down before considering how to let your profits run further. And, keep current, accurate records. Relying on memory to determine results allows the mind to play cruel tricks.

Finally, consider the real nature of your trading account size and leverage. The well-greased competition can overcome transaction costs by moving large blocks. Balance the leverage of your account against the costs of taking positions. And, use drawdowns as a signal to lighten up and slow down.

*Reprinted (and modified) with permission from Alan Farley