Short-term Daily Momentum Approach

It has been scripted lots of times that a strong trending market overtimes pulls back a few days, back to the 20MA earlier resuming with the course. This strategy's aim is to take advantage of this type of market behavior. The scheme aim, in a nutshell, is to describe a strong market trend, by using the ADX +DI -DI. Then using the stochastic to note the exhaustion of the short term pullback that is being oversold. The entry comes from buying a new high of the previous day. The major indicator components to the system are: Directional Movement +DI, -DI, ADX (developed by J.Welles Wilder) Stochastic K% (developed by George Lane) Moving Average. MA 20

Directional Movement indicator

The Directional Movement indicator Contains the ADX and +DI, -DI. The +DI and -DI identify the direction of the trend. Because an up-trend the +DI have to be above the -DI and the reverse for a downswing. The ADX measures the strength of the trend, but not the direction. In this strategy, we are looking for stocks with an ADX over 35.This will assist in identifying strong trending markets. (See charts below)
The Directional Movement indicator

In the chart below shows the components +DI and -DI. For an up-trend the +DI must above/cross over the -DI. Can you view where this occurs? (The green +DI line crosses the red -DI) Also note the histogram. Chart Above: Directional Movement.

ADX indicator

In the chart below, I have highlighted the black line which is the ADX. I have also drawn an orange line horizontally at 35. The ADX line is crossing above the 35 level or 35 percentages, this indicate that this market is in a strong trend. As mentioned earlier the ADX indicates the strength of the trend and above 35 (point B) is a strong trend. Also remember that the ADX does not give the direction of the trend, just the strength of the trend, as this could be a strong trend down? What does make this a trend up (point A) is the (green line) +DI crossing over/above the (red line) - DI and vice versa for a down trend, there are subtle points to the +DI and -DI that you will come to understand through observation. However for this strategy it is straight forward in terms of the signal, that is simply on the long side the +DI must be above the -DI.

Summary

This indicator is part of the overall strategy and has two parts to it, that is the ADX must be over 35 and the +DI must cross over and be above the -DI for the up-trend. And vice versa for adown trend, for a down trend the ADX would need to be around 60. In the chart below, two positive signals have occurred, firstly the green line has crossed the red meaning that the +DI crossed the -DI. Secondly the ADX crossed 35. NOTE: as long as the +DI is ‘above' the -DI, is the important point here, you don't have to get it right on the cross over. As mention earlier there are many subtle points regarding the +DI and -DI that you will begin to notice, such as the way they move in and away from one another - notice what is happening in the market while these two indicators are expanding and contracting. Chart: Directional Movement with -DI (red) & +DI (green)

Stochastic indicator

Stochastic indicator is the next portion of the strategy. There are a few major aspects to the stochastic. In this strategy we are only concerned with the Fast % K. This acts the quickest and will assist in measuring the overbought and oversold conditions in the market. It is important to understand how indicators are calculated and what they reflect. In a nutshell the concept behind the stochastic is that, as prices rise, the closing prices of that period tend to close higher and as prices fall the closing price tends to close to the lower end of the periods trading range. In this short term trading strategy we will set the stochastic fast % K on 8. whenever you're using the stochastic in MarketMaker there will be two horizontal lines in the stochastic window set 20 and 80 you can right click on those lines and change them to 40 and 60 ( you can also change them from the properties window) The setting for the stochastic horizontal lines are 40 and 60. These are the overbought and oversold parameters we will use for the strategy. The 40 is the oversold, so if we are going to go long we want the % K (setting 8) to pull back to or below the 40 indicating that the market is oversold. If we were going short, then we would simply use 60 or higher indicating the market is overbought. The Stochastic chart below demonstrates the % K 8 at or below the 40 level indicating the market is oversold. We will use this concept in conjunction with the other indicators. Chart: Stochastic The Trading Strategy thus far… We are only interested in trading the stocks that are in a powerful trend. Using the ADX above 35 and the +DI above -DI. The higher the stock price the best, significant better results have come from stocks priced above $50 than stocks from $30. So the price is very important, this method would suit US and European markets. Do your research and test. The example I'm using here is RIO Australia around the $40. The 20 MA. The market is pulling back to the 20 period moving averages. Stochastic, wait for the pullback of the Fast % k to the 40 level.

The Stochastic setup.

Next: the entry using the bar chart on the chart below, RIO is in a strong up trend, with the ADX above 35 with the +DI traveling above the -DI. The market then pulls back for the classic 3 day pullback to the 20MA. The stochastic Fast % k is at 40 (oversold). The entry is the new high above the previous day's bar and the initial stop loss goes under the previous day's low. It is also very important that we are looking for the 3day pull back in the stock, if it is any more than that let the trade goes, as this may mean it's a larger correction and not just a pull back. Too take into account where you are in the market that is key numbers such as the Trading Levels®, you need to be in a strong trend, this will give you the low risk verses the profit. Bringing the indicators together in the chart below for the trade set-up. The market pulls back for a 3 day correction onto the 20MA Directional Movement indicator: ADX above 35 and the +DI above -DI Stochastic Fast % K must be around 40. (Oversold) Buy above yesterdays high. (If you are not filled, then look to get the next day one point above the last high) once you are filled, your stop is place one point below the preceding days low. This is demonstrated on the chart as the number 2. The chart below, the 20MA and the bar chart with entry method. The stochastic has pulled back to the 40 level or 40 %. The Directional Movement indicator with the ADX above 35 and the +DI above -DI The chart displays the short term entry set-up and initial stop loss at 2 (in red) which is under the previous bar's low.

Exiting Positions

Once your initial stop loss is in place, under the previous day low. Then the exit is simply on the 4th day. You are just catching the momentum of this trade. The second type of exit is more sophisticate and requires more attention. This is to maximize the profits. Once you are triggered into the trade, place the initial stop under the previous day low. This concept is using a trailing stop loss, your first aim is to lift your stop to the break even - so if your initial risk is $1, when the market moves up lift your stop up $1. Then you have nothing to lose. When the price moves double your initial risk i.e. $2, then sell half - taking half the profit. Then use the lows of each previous day. If you would like to capture the longer trend then use the low of the weekly low as the trailing stop loss.

More on the Indicators:
Directional Movement DI - Directional Indicator Calculations:
DI+=DM+/TR
DI-=DM-/TR
TR=maxabs (Highest-Lowest); abs (Highest-CloseDayBefore); abs (Lowest-CloseDayBefore)
DM+=max0; Highest-HighestDayBefore DM-=max0; LowestDayBefore-Lowest the parameter measures the number of days essential to smooth both lines using the moving norm system. In histogram mode, the bars are DI+ minus DI- Interpretation: The DI+ measures upward movement. The DI- measures downward movement. A buy opportunity may appear when DI+ crosses above DI- and a sell signal when DI+ crosses below DI-. These signals are mostly valid when there is a trend. ADX should thus be higher than a certain figure. Stochastic - Fast/Slow Calculation: The first parameter is the number of days used to calculate %K, the second is the number of days to be considered for the moving average of %K (generally 1 for Fast Stochastic and 3 or 5 for Slow Stochastic), and the third is the number of days to be considered for the moving average of %D. Reading: It is an overbought/oversold indicator depending on its perspective relative to the 0 level. It also gives good divergence signals. A bullish divergence occurs when the stock price makes new lows when the Stochastic fails to create new lows. A bearish difference occurs when the stock price makes new highs while the Stochastic fails to do fresh highs.