Momentum is an oscillator, used in technical analysis, which indicates the variation between two closes in a given period. That is, it calculates the variation in points or percentage of the price from a given day to today.
The indicator implies, by its construction, the concept of acceleration speed, therefore, it is considered an advanced indicator. That is, it presents its turns anticipating the price chart.
To explain it in another way, the momentum indicator allows us to identify a turn or the beginning of a new trend before it can be seen on the price chart.
Momentum as a Technical Indicator
The momentum indicator is used to measure the strength with which the value's quotation rises or falls in the given period. It allows us to establish in which phase of the movement the value is:
- Ascending accelerating
- Ascending decelerating
- Descending accelerating
- Descending decelerating
- It is used to perform divergence analysis
Calculation and Interpretation of Momentum Indicator
The momentum indicator uses as a default parameter the period of 12 sessions (although in this not all sources agree, since some refer to a little more or a little less of sessions).
Its calculation can be done in two ways, according to the sources reviewed. First, with the direct subtraction of the value of the last closing against the closing of n days ago, where n is the number of sessions selected. We will call this method 1.
The other way, method 2, is by dividing the current closing by the closing of n days ago and multiplying by 100.
Momentum = [(Current closing) / (Closing of n days ago)] X 100
We will include for our analysis a zero line or neutral line which is equivalent to a value of 0 or 100 for the indicator, depending on whether method 1 or 2 was chosen, respectively. That is, if the indicator touches this line, it means that during the period of interest, the quotation has not changed.
When analyzing the momentum, it is necessary to take into account mainly its direction and its relative position and not its value, particularly if we use method 1 where we have calculated the difference between prices (which is an absolute value and not a percentage).
The greatest usefulness of the momentum is perhaps its anticipation of the turns that occur in the price chart, which will usually be alerted with a divergence.
Strategies with the Momentum
A strategy to follow, taking the momentum as a trend Indicator, is:
- Buy or go long when the moment (momentum) crosses upwards the neutral line.
- Sell or go short when the moment (momentum) cuts down the neutral line.
Strategies can also be based on divergences:
- Bearish divergence: When the price is touching highs, and the momentum rises vertically, but then decreases. At the same time, prices are still rising or showing a lateral trend. This scenario is interpreted as a sell signal.
- Bullish divergence: When the price touches lows, and the momentum drops sharply, but then begins to rise before the same happens with the quotation, which continues to drop for a few more periods. In this scenario, the trader sees a buy signal.
Another important point is that strategies can be approached from two perspectives. One is in favor of the trend. This is when a trend is observed, and the momentum reinforces or confirms it. For example, the trend is bullish and the indicator exceeds the neutral line. In this case, a long position would have to be opened, under the forecast that the rise will continue.
But, a strategy against the trend can also be implemented. For example, if in the middle of an upward trend, the indicator reaches an upper extreme, it could be interpreted as a signal to sell. This is because it is expected that, after reaching that maximum, the quotation will then retreat.
Momentum and Other Indicators
Let's think of a strategy like the following:
If the MACD crosses the signal line upwards, probably a bullish movement will start. If, in turn, we observe a strong rise in momentum, this would confirm that we could enter the market taking a long position.
An additional note: The further the indicator is from the neutral line, either up or down, the more security there will be about the circumstances of overbought or oversold, respectively.
What is the purpose of the momentum indicator?
The momentum indicator helps traders identify trend strength, potential reversals, and divergence between price and momentum, aiding in buy/sell decisions.
How can traders use momentum in their strategies?
Traders can use momentum to confirm trends or spot divergences. Buy when momentum crosses above the neutral line, and sell when it crosses below
Can the momentum indicator be combined with other indicators?
Yes, traders often use momentum alongside indicators like MACD or RSI to strengthen the trading signals and improve decision-making.