Check the momentum behind any break out

DESPITE a summer where equities drifted sideways and the recent slew of less upbeat economic data, the FTSE 100 has had a promising start to the autumn. Since the start of September it has risen around 400 points to close yesterday at 5,602.4 and some market participants are anticipating another move higher.

“UK equities are cheaper than they were in March 2009, and represent the bargain of the decade. It is clear to us that the markets are now entering a bottoming phase and that the next move is higher. We expect the present uneasy tension to break soon and to the upside. When it does so, we are poised and will be ready to act,” says Paul Meader, head of Guernsey Portfolio Management and a member of Collins Stewart Wealth Management’s asset allocation committee.

But the markets are still bouncing around all over the place and market moves are failing to gain traction. For example, the blue-chip index tried to break through the 5,610 level on Friday but was rejected and sank sharply in afternoon trading to close the week at 5,525. So how can contracts for difference (CFD) traders tell when the break higher actually happens? There are a number of indicators that they can use to confirm a move in a market before jumping in.

First, check the volume. A break needs to be supported by sufficient volumes if it is to be sustained. A surge through a resistance level with only minimal volume is more likely to be a fake-out than a breakout.

Second, look at the trendlines. “A break of a trendline confirms that the trend is no longer continuing at the same pace, which can be the first indication of a turn, or a pause,” says Tom Pelc, head of technical analysis at RBS. “But if the original trend was very steep, a break may just signal a return to a more normal gradient,” he adds.

Third, momentum indicators can signal the strength of a break higher (or lower). Look at the relative strength index (RSI), which tries to determine the overbought and oversold conditions of an asset by comparing the magnitude of recent gains to recent losses. The RSI ranges from 0 to 100 and once it nears 70, the asset is seen as overbought and may well see a pullback. If it falls to 30, then it is seen as oversold and probably due a recovery bounce. The RSI on the FTSE 100 has risen sharply to verge on 70 but the RSI has turned down in the past week to 61.76, indicating that the blue-chip FTSE is starting to appear better value. Watch for a fall towards 50 before buying.

If you are looking to verify a genuine break higher, look for a whole day’s trading or two consecutive closes above the trendline. This, combined with the other signals, should filter out the fake-outs and ensure you don’t jump in too late.