Understanding Momentum in Stock Trading

Very popular with traders, the momentum indicator pinpoints when the price is moving upward, downward and how strongly. It is the most widely used tool and allows professionals or less experienced traders to make better decisions. Momentum indicates the rate of change in prices as opposed to the actual price changes themselves. It’s measured by continuously collecting price differences for a settled time period.

Understanding Momentum

Momentum, also called “rate of change”, is one of the most widely used indicators in technical analysis. It belongs to the oscillator class of technical trading indicators.and measures the speed of change of stock market prices over a certain period of time. It is very versatile and suitable for different types of markets, such as stocks or the Forex, but also for different types of trading, such as position trading or intraday trading. With this indicator, traders are able to clearly identify the current trend (up or down) and make the right decisions. A momentum value above zero indicates that the price is moving up and a momentum value below zero suggests that the price is moving down. Momentum in finance is based on the following key factors: volume, volatility and time frame.

Volume is not the number of transactions, but the number of assets traded withing a given time frame. It is vital to momentum traders since they need to be able to enter and exit positions swiftly.

Volatility is the degree of change in an asset’s price – if a market is highly volatile, it means that there are big price swings, while a market with low volatility is comparatively stable. As a momentum traders you should seek volatile markets to take advantage of short-term increase and falls in an asset’s value.

Finally, momentum trading strategies are suitable for traders who wield longer-term styles such as position trading, as well as those who prefer short-term styles, such as day trading and scalping. These strategies are usually focused on short-term market movements, but the wield of a trade can lean on how long the trend maintains its strength.

Some sites, like Market-Signals for example, offer investment strategies based on Momentum.

Calculating Momentum

The formula for calculating Momentum is: Momentum= CP – CPn

The momentum (M) is a comparison between the current closing price (CP) and a closing price “n” periods ago (CPn). You determine the value of “n.”

The vast majority of technical analysis software offers the calculation of this indicator. All the trader has to do is set it to the desired number of periods. Nevertheless, it is always possible to calculate it since the calculation is a simple subtraction.

Measuring Momentum

2 optimum interpretations are possible:

  • The use of high and low extremes

Detecting reversals is one of the first steps in using extremes. The higher the momentum is, the more the stock is overbought, and conversely, the lower it is, the more the stock is oversold.
To be able to detect these overbought and oversold areas, it is recommended to go back over a period of at least 12 months. The extremes are specific to each stock or index and will depend on the volatility of the stock or index.

  • The use of divergences between price and momentum

The interpretation of divergences is very relevant whether it is a few days or a few weeks and is considered by many to be the best possible use of this indicator. A bearish divergence can signal weakness in the current uptrend, while a bullish divergence can presage an upcoming price rally, and thus encourage buying. Nevertheless, it is better to study all the information at your disposal before jumping in.

Calculating and interpreting momentum is quite simple and is made even more intuitive by trading platforms that calculate and display momentum on a chart very quickly.