By Gary Stone
A vital aspect of being able to trade the markets successfully is a trader’s ability to recognise trade set-ups and market moves. Just like a ship captain who bases his decisions on the ebb and flow of the tide and direction of wind, a trader uses technical analysis to recognise the up and downward cycles of individual stocks and overall market direction.
Technical indicators are widely used to identify these cycles as their algorithmic nature. In combination with a securities price action, they can be monitored and measured with a formula. One of the more commonly used types of indicators is a momentum indicator. Momentum and Rate Of Change indicators show trend direction by rising while an uptrend is continuous or falling while a down trend is continuous. For the trader, a momentum indicator can help identify if a security is performing above or below its average.
To understand the benefit of using a momentum indicator, I will explain the use of the SIROC indicator. SIROC stands for Smoothed Index Rate Of Change. When combined with the Relative Strength Comparison indicator, the SIROC can identify the stocks that are on the rise and outperforming the market. The SIROC is indexed between 0 -100 which makes determining the overbought and oversold zones more objective to the trader. In comparison to other momentum indicators, the SIROC shows more consistent and smoother slopes, peaks and troughs, thus making it easier to see which stocks are sitting within the overbought or oversold zones.
For those familiar with technical analysis indicators, the SIROC can be viewed as a combination of a MACD and an RSI or Stochastic. It has the smoothness of the MACD and the indexing of the RSI or Stochastic.
The image below contains 3 separate JB Hi-Fi charts. First is the weekly price chart (1), the middle chart is the SIROC indicator (2) and the bottom chart is the RSC – Relative Strength Comparison (3).
Let’s take a closer look at the SIROC chart, i.e. chart (2). The blue line is the SIROC and the green line is a 5 week exponential moving average (EMA) of the SIROC. When the blue line of the SIROC crosses above the green line (EMA 5), it means that the stock’s price momentum is positive. When the blue line of the SIROC crosses below the green EMA line, then the stock’s price momentum is negative. As investors, we are looking for the periods when the SIROC is positive, as this is an indication of continued price strength. A core objective of a trader is to outperform the market and as such, the SIROC indicator is not used just on its own. There are instances where a security is rising but the index is rising faster. This is why the SIROC indicator is used in conjunction with the RSC indicator.
The RSC indicator is the blue line represented in chart (3). When the RSC is above its EMA it suggests that the stock is outperforming in the overall market. When the RSC is below its EMA it suggests that the stock is under performing in the broader market. So, we want to avoid the periods when the stock is under performing and buy the stock when it is outperforming. We now combine the use of the SIROC and the RSC. When the RSC is outperforming, and the SIROC is showing positive momentum, we choose to buy. As these signals are measurable, when using the right tools, this approach can be systemised and automated as seen on the charts below. The green signals to buy only appear once all the RSC and SIROC criteria have been met.
On the chart JBH chart above, you can clearly see the buy (green) and sell (red) signals displayed in chart (1) during 2009 and 2013. However, throughout much of 2010 -2012, JBH was in a clear down trend retracing approximately 50 per cent from its peak. Although the SIROC indicator did experience some short term rises during this period, due to a small number of rallies, JBH was under performing the market index (as seen by the RSC in the chart (3) declining and tracking below the EMA). As securities must have been outperforming the market for our system to deem them worthy, JBH was not a consideration. During this time, the money was better used in something that was outperforming the market and therefore invested elsewhere.
Eventually the tide turned and in March 2013 JBH began rising faster than the market index. Shortly afterwards, a medium term buy signal was generated by the automated system and JBH was considered again. JBH continued outperforming the market with a strong SIROC until late 2013. The SIROC indicator helps identify securities that are rising in the medium term and the RSC complements it by ensuring that they are outperforming the market.
Gary Stone has more than two decades of experience and is founder of Share Wealth Systems, a leading provider of share market trading strategies.