CHARTING THE MARKET

Momentum

Momentum... The Big Mo... Is there anything in the physical world more exciting than momentum? If you're going slowly and you gain momentum, you're going faster. If you're already going fast and you gain momentum, watch out! Speed may be king, but momentum is what propels unknown political candidates into front-runner status, what makes a team ending the regular season on a 10-game winning streak a real terror when the playoffs start. If it is true, as Madison Avenue would have it, that things go better with Coke, then things go great with Mo.

And technical analysis is no exception. Many technical approaches to the market attempt to identify both the presence of trends and the likelihood of those trends to continue or reverse, and momentum can be a valuable tool in determining the strength of a given price advance or decline. As John J. Murphy wrote of momentum indicators in his Technical Analysis Of The Futures Markets:

It is important to remember that momentum measures the difference between prices at two time intervals. In order for the (momentum) line to advance, the price gains for the last day's close must be greater than the gains of 10 days ago. If prices advance by only the same amount as 10 days ago, the momentum line will be flat. If the last price gain is less than that of 10 days ago, the momentum line begins to decline even though prices are still rising. This is how the momentum line measures the acceleration or deceleration in the current advance or decline in the price trend.

A number of technical indicators measure momentum in different ways. Many of these indicators fall under the rubric of oscillators such as stochastics, rate of change (ROC), the relative strength index (RSI), Williams' %R, and the moving average convergence/divergence oscillator. But even a simple momentum indicator can inform traders and investors about the strength or weakness of a given price movement. Murphy states that to measure momentum, a trader simply needs to compare the difference between prices at two points in time. His preference is for two points 10 days apart, but depending on the preferred sensitivity of the indicator, this duration can be extended or reduced.

The equation for a momentum indicator is especially straightforward:

M = C - Cn

where M stands for momentum, C represents the most recent closing price, and Cn represents the closing price n periods ago (periods may be daily, weekly, or five-minute price bars).

This simple momentum indicator can be used in a number of ways. Perhaps the most common is by locating divergences between the momentum indicator and price action. As Murphy noted, there are instances in which a momentum indicator will turn down while prices continue to move up. Such instances often presage significant divergences between momentum and actual price action, divergences that can help traders and investors anticipate a market's move.

Consider the chart of December crude oil in Figure 1. You can see that many short-term peaks occurred during the summer of 2003, any of which might have appeared to be the peak at the time. However, the stark divergence between the two peaks in this 12-period momentum indicator at the beginning and end of August, compared to the peaks in price action at the same times, would have provided clear indication that the real peak in December crude did not come until the latter peak in late August. In addition, the exceptionally low level of the momentum indicator suggests that the downside is limited, at least temporarily, and that a bounce may be necessary before December crude continues with its declines.

Figure 1: 12-period momentum indicator. Note where price and momentum diverge.

Momentum analysis can be valuable for more than trend confirmation. In fact, momentum indicators can help traders and investors avoid markets that have already moved too far, too soon. Often, markets will appear to present strong trends, with up day after up day leading prices higher. However, a glance at a momentum indicator may reveal that a market that looks poised to surge higher may actually be at a momentum extreme (that is, overbought) and ripe for reversal. Even if the market is not on the verge of a reversal, an extreme in a momentum indicator can at least provide traders with a sense of when risk may have shifted from a can't-lose opportunity to a better-be-cautious reality.

--David Penn, Technical Writer

Learn more about momentum indicators!
Chande, Tushar [1993]. "Stochastic RSI And Dynamic Momentum Index," Technical Analysis of STOCKS & COMMODITIES, Volume 11: May.
Ehlers, John [1989]. "Leading Indicators With Momentum," Technical Analysis of STOCKS & COMMODITIES, Volume 7: September.
Evens, Stuart [1999]. "Momentum And Relative Strength Index," Technical Analysis of STOCKS & COMMODITIES, Volume 17: August.
Lawlor, John C. [1988]. "Cumulative Volume And Momentum, Part 2," Technical Analysis of STOCKS & COMMODITIES, Volume 6: February.
Murphy, John J. [1986]. Technical Analysis Of The Futures Markets, New York Institute of Finance.
Oliver, Michael and Gary Esayian [1993]. "Momentum And The S&P 500," Technical Analysis of STOCKS & COMMODITIES, Volume 11: January.
Pring, Martin J. [1993]. "Internal Market Momentum," Technical Analysis of STOCKS & COMMODITIES, Volume 11: July.
Warren, Anthony W. [1994]. "Optimizing Momentum," Technical Analysis of STOCKS & COMMODITIES, Volume 12: April.

Originally published in the November 2003 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2003, Technical Analysis, Inc.


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