Tips on Technicals - Momentum
Many technical indicators used today are trend following systems that are used to confirm a change in market direction has already taken place. For example, a moving average turns down after the market peaks because it averages old prices in with recent prices. Momentum indicators, however, are more predictive. They measure the speed of price movements, not the prices themselves.
Momentum defined*
When a ball is thrown up into the air its speed (velocity) declines until it stops momentarily in mid-air and then starts to fall. While the ball is still rising, its speed is falling. Markets exhibit this behavior as well. If we could determine that the speed of rising prices is declining, we would then be forewarned that a market top may be near.
For falling markets, we can use another analogy. Take the same ball to the top of a hill and let it go. As it rolls down the hill it gains speed. When it gets to the bottom it is still moving but since the ground is now flat, its speed starts to decline.
These examples help show that a market will tend to continue in the same direction in which it is moving until some force acts on it. These forces are called support and resistance. If a market is moving but does not meet either support or resistance, it will continue to move in the direction of the trend, but at slower and slower speeds until it just stops, like a tired long distance runner. The buying or selling pressures that powered the move have dissipated.
Reading a Momentum Chart
There are four basic events to follow on a momentum chart. The first is a crossing of the zero line. If momentum is negative and crosses the zero line to positive territory, it could be a buy signal. This is because prices are accelerating their advance as new buyers enter the market. Note that this is only a valid signal when the line is crossed in the direction of the prevailing trend. Trends are still more important than their derivative measure, momentum.
The second event is a divergence with price action. If prices make lower lows but momentum makes higher lows, down side market momentum is declining.
Figure 1
Figure 1 shows a 200 day bar chart of September 1994 NYMEX Crude Oil futures with a 39 day moving average and a 10 day momentum indicator. In March, while the market was still falling, momentum was becoming less negative. In other words, the speed of the market was declining, indicating that selling power was weakening. Note that during the period of divergent momentum, the indicator crossed the zero line several times. Since the trend in the market was down, these zero line crossings were ignored.
In April, the market trend did reverse as priced began to rally. Momentum was in positive territory and settled into a two month range. Finally, in early June, momentum crossed below the zero line. Since the primary trend was still up, this signal was ignored. Other technical indicators, such as the moving average itself, confirmed this as prices bounced off support.
Later that month, momentum reached a level which was very high as compared to its recent history. This is the third event and may indicate an overbought condition. Since momentum is not indexed, like RSI or Stochastics, we must make a judgment call to determine if a level is overbought or oversold. The signal given suggested that the market may need a short rest and that new long positions should not be taken.
Sometimes, when the ball in our analogy above is thrown up it bounces off the ceiling. In this case, both prices and momentum change at that same time. In this situation, trend breaks in momentum can be useful in place of first three basic events.
To date, we have seen that momentum has made declining peaks as the market continued higher. There have been several zero line crossings, but again, the trend is still up so no short positions should have been taken. However, this would normally indicate that the market is near a top but in late July, momentum broke through its own down trend line (event number four) indicating new buying pressures and more gains to be made.
Conclusion
Momentum is a very useful leading indicator but it must be used as an opportunity finding tool, not the final decision making tool. Confirm all signals with trend breaks and other technical signals, such as reversal patterns on bar charts.
* Momentum is calculated by taking the current price and subtracting the price n-periods ago. It is very similar to the Rate of Change indicator calculation.
