So far we have discussed in general terms how the Price Momentum Oscillator (PMO) is used as a traditional technical indicator. Now we will demonstrate how to use the PMO to make buy and sell decisions in the context of an integrated analysis process. This is intended as (1) an overview to give beginners a general idea of how to approach analysis and arrive at action decisions, and (2) to give experienced traders and investors more detail regarding the PMO as an analysis tool.

EVALUATING THE TREND OF THE MARKET

An investing truism is that "a rising tide lifts all boats," meaning that the majority of stocks will follow the primary trend of the broad market. Yes, some stocks will buck the trend, but you are far better off to skew your investing or trading strategy so that the tide of the market carries you along, not the other way around.

When I first began my market studies many years ago, I picked about 30 stocks out of the 150 or so that I followed for a paper trade as a test for an timing model I was developing. At the end of the test, about 28 of the 30 stocks were winners. Had I found the Holy Grail? Well, yes, but it was not my timing model. I had quite simply, and by accident, run my test at a time when the market made a strong up move, which took my reasonably good stock picks along for the ride. I didn't fully realize it at the time, but the true Holy Grail is to make your move, long or short, at a time when the market wind is at your back. Look at all the geniuses the market created from 1995 to 2000.

To determine the trend, we want to look at the time frame one level higher than the one in which we are working (see Trading for a Living by Dr. Alexander Elder; elder.com). Since we'll be working in the daily (short-term) time frame, we'll use a weekly bar chart (each bar equals one week) to make our determination regarding the trend. On the chart below the trend lines indicate that the long-term trend is down, but we can see the intermediate-term trend moving up and down within that declining trend channel. Obviously the trend can be determined by the direction of the channel which envelops the movement of the price bars, but it is to our advantage to detect changes in the intermediate-term trend early. To do this we can use direction changes of either the weekly PMO or the weekly MAC-D histogram. These indicators will detect changes in trend at the turning point, and they confirm the direction of the price trend when they persist in one direction or the other.

EVALUATING THE CONDITION OF THE MARKET

After we have determined the trend, we want to know the condition of the market -- is it overbought or oversold? If we are going long, the best time to execute is when the trend is turning up from oversold conditions. The opposite is true for going short. To determine the market condition, we watch for an indicator to reach the extremes of its normal range. In the chart above, the MAC-D histogram is obviously useful in this regard, but one of our favorites is the PMO Analysis charts.

Decision Point tracks the individual stocks in the S&P 500 Index (and for several other major indexes as well), and we are able to compile statistics on (1) the percentage of PMOs rising, (2) the percentage of PMOs on crossover buy signals, which means the PMO is above its 10-EMA, and (3) the percentage of PMOs above zero. When we plot these data we get three indicators that address three different time frames -- percentage rising being the shortest, and percentage above zero being the longest. The indicators are overbought when they are at the top of their normal range, and oversold at the bottom. The percentage above zero is best for judging intermediate-term condition and identifying important turning points, The other two help us refine the timing of the the turning point, as well as help us decide when to add to or scale out of positions in between the major turning points.

The reliability with which overbought/oversold conditions identify actual price tops and bottoms will depend upon the direction of the primary trend. For example, in a bull market, topping signals given by technical indicators are only correct about 20 to 30 percent of the time, and in bear markets they are 70 to 80 percent reliable. This concept is extremely important. Don't forget it.

PMO TRADING SIGNALS

Once the trend and condition of the market have been evaluated, we are ready to zero in on the chart of a security in which we wish to take a position. For this discussion we will use the S&P 500 Index chart, but the same analysis can be applied to any security that might be expected to follow the trend of the general market.

PMO Crossover Signals: The basic PMO action signal is generated when the PMO crosses its 10-EMA -- crossing up is a buy, down is a sell. While this is a simple rule, it cannot be applied mechanically because there is too much noise (whipsaw) in the center of the PMO range. Let me emphasize this point. Trying to mechanically follow all PMO signals over a long period of time will almost certainly result in a large net loss, because of all the noise that occurs in the middle of the PMO range. PMO signals should be viewed as discretionary, not mechanical.

Before we consider acting on a PMO crossover signal we will want the trend and condition of the market to be favorable, and we will want the PMO crossover to occur near the extreme limits of its normal range so that we are taking advantage of overbought or oversold conditions.

On the chart below we have highlighted particularly good signals. After you have studied those, look at the other crossovers so that you fully understand the ambiguity that exists in real time analysis. The PMO signals are very useful in the decision process, but there is always risk and uncertainty. Generally speaking, the most reliable signals take place when the PMO is near the extremes of its normal range, and after a clean, straight run up or down. We will discuss specific configurations in Part 5 of this series.

PMO Direction Change Signals: It is obvious from the chart above that we can exploit a change in trend earlier if we act when the PMO changes direction, rather than wait for a crossover signal. It is also obvious that there are many, many false signals, so a very short-term horizon should be maintained until the signal proves itself. Sharp, decisive direction changes that occur near the extremes of the normal PMO range are the most reliable signals.

Position Management: What we have shown you so far implies that you should open and close positions based solely on PMO signals, but that may not always be the best course of action. The PMO is an oscillator, and the mathematics involved demand that it must oscillate; however, the price trend may continue its direction even as the PMO reverses. This is particularly true in a bull market, where it is common to see internal corrections take place (the PMO corrects downward) as price continues to move higher. This is called Trend Bias. If you believe the primary price trend is likely to override the internal indicators, you can tighten your stops and let a price reversal make your exit decision for you.

Conclusion: Above we have outlined the steps of a rudimentary analysis and decision process that is simple and should be effective. It is not a totally mechanical system -- it requires judgment, which is acquired through study and experience. The material presented represents only a tiny sliver of the tools and techniques available to the technical analyst. We have purposely limited our discussion to only price-based , PMO-centric indicators, because the PMO was the central theme of this series of articles; however, we highly recommend the inclusion of other technical tools, such as breadth and volume studies, to inject more depth in your analysis process. Our purpose here was to present a brief overview of the process in general, and of the PMO in particular.

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