THE PRICE MOMENTUM OSCILLATOR (PMO) AS A TRADITIONAL ANALYSIS TOOL

Decision Point's Price Momentum Oscillator (PMO) is based on a Rate of Change (ROC) calculation that is exponentially smoothed. Since this is an internal ratio calculation (versus external, which uses another price index for calculating the ratio), it returns a result that can be compared to an identically calculated ROC result for any other security or index.

The PMO was originally designed as a device for analyzing price momentum using a calculation similar to that used for our ITBM and ITVM (IT Breadth and Volume) Oscillators. The object was to be able to analyze price, breadth and volume from an identical platform. I later developed the current , less complex PMO formula and decided to abandon the original formula because the PMO curve was about the same, and we gained the added benefit of being able to use it to make relative strength comparisons.

The fact that two completely different calculations would result in two oscillators that were virtually the same shape surprised me, but I have since discovered that there are at least five different calculations that will do this, one of which is the MAC-D (Moving Average Convergence-Divergence) invented by Gerald Appel. The chart below shows the PMO and MAC-D together.

You can see that they are very similar in shape. The PMO runs a little slower and generates fewer crossover signals, which may work in your favor or against you depending on the circumstances, but, if you know how to use the MAC-D, you can apply the same rules to the PMO. The other difference, of course, is the absolute value of each indicator. The MAC-D is based on moving average calculations, and one MAC-D reading bears no relationship whatsoever to another.

While the PMO and MAC-D have similar shapes on shorter-term charts, the advantage of the ratio-type calculation for the PMO is evident because the PMO maintains a fairly constant range on longer-term charts. This allows us to use the PMO as an overbought/oversold indicator in addition to its other uses. See the weekly and monthly charts below.

Let us now discuss the role of the PMO as a traditional analysis tool.

OVERBOUGHT-OVERSOLD INDICATOR

As we demonstrated above, the PMO can help us determine if its price index is overbought or oversold. Below is a seven-year chart of the S&P 500 Index showing a wide range of extreme market conditions. If we ignore the extreme spikes, we can see that the normal PMO range for this index is from about +2.5 (overbought) to -2.5 (oversold), and, when the PMO approaches those limits, it is wise to start looking for a price reversal. When the PMO changes direction at or beyond the extremes of its normal range, it is a fairly reliable indication that an intermediate-term change in price direction is taking place.

While +2.5 to -2,5 is the usual range for broad stock market indexes, each price index will have its own "signature" range. For example, the chart of IBM below shows a range of +5.0 to -5.0. Always check a longer-term chart to verify the normal range for the index you are analyzing.

Also, remember that technical indicators are calculated based on a specific number of time periods within the time frame being addressed, so a monthly PMO looks completely different from a daily PMO. See the monthly based chart below which uses the same seven year period as the two charts above.

MOMENTUM INDICATOR

As a momentum indicator, the PMO expresses the direction and velocity of price movement. In this regard it is like other momentum indicators. It is not our purpose to thoroughly cover this topic here, rather to provide an overview. Newcomers to technical analysis will need to conduct more extensive study on their own. On the chart of Amazon.com below we can see that the strongest moves in either direction are characterized by straight, steep, smooth PMO movement. More halting trends usually are accompanied by frequent PMO direction changes. Finally, like other oscillators, the PMO gives us hints of important direction changes by forming divergences against the price index. Below we have highlighted three separate divergences. The two negative divergences (red lines) warn of important tops as the price index makes a higher high, and the PMO makes a lower high. The Positive divergence (green lines) signal an important bottom with price making a lower low while the PMO makes a higher low.

SIGNAL GENERATOR

The PMO generates a crossover BUY or SELL Signal when it crosses up or down through its 10-EMA. These signals tend to be short-term in duration, but they can last for several weeks. Do not take them at face value because they can whipsaw quite a bit. They should be used to alert you to possible trading opportunities not used as a mechanical trading model. Always check our daily stock charts to verify the price pattern and the configuration of the PMO. Signals are best when price appears extended, is near support or resistance, and the PMO is very overbought or oversold. These signals may also be used to manage positions based on our Price Momentum Model signals.

The most reliable signals are generated when the PMO is near the extremes of its normal range, or when a direction change and crossover occurs following a strong, clean, straight PMO move. Quite a bit of "noise" can be generated around the zero line and while the PMO is moving in a relatively flat pattern. We will study specific patterns in a later chapter. For now, we have highlighted some crossover signals on the chart below (green arrows for buy, and red for sell).

In our daily reports we track PMO crossover signals for hundreds of stocks, mutual funds, and market indexes. Below is an extract from one of those reports.

Next we will examine how the PMO is used for relative strength ranking.

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