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TECHNICAL TOOLBOX: Breaking Down Momentum Indicators

http://www.optionetics.com/articles/article_full.asp?idNo=8653

By Andrew Neyens, Optionetics.com
7/7/2003 7:00:00 AM

The concept of momentum is the most basic application of oscillator analysis. Momentum measures the rate of change of prices as opposed to the actual price levels themselves. Market momentum is measured by continually taking price differences for a fixed time interval.

To construct a 10-day momentum line, simply subtract the closing price ten days ago from the last closing price. The positive or negative value is then plotted around a zero line. The formula for momentum is:

M = V – Vx

where V is the latest closing price and Vx is the closing price x days ago.

If the latest closing price is greater than that of ten days ago then a positive value would be plotted above the zero line. If the latest close is below the close ten days earlier then a negative value is plotted below the zero line.

While the 10-day momentum is a commonly used time period any time period can be used. A shorter time period produces a more sensitive line with more pronounced oscillators. A longer number of days results in a much smoother line in which the oscillator swings are less volatile.

What just is it that momentum measures anyway? By plotting price differences for a set period of time, the chartist is studying rates of ascent or descent. If prices are rising and the momentum line is above the zero line and rising, this means the uptrend is accelerating. If the up-slanting momentum line begins to flatten out, this means that the new gains being achieved by the latest closes are the same as ten days earlier.

While prices may still be advancing, the rate of ascent has leveled off. When the momentum line begins to drop toward the zero line, the uptrend in prices is still in force, but at a decelerating rate. The uptrend is losing momentum. When the momentum line moves below the zero line, the latest 10-day close is now under the close of ten days ago and a near term downtrend is in effect. As momentum continues to drop farther below the zero line, the downtrend gains momentum. Only when the line begins the advance again does the technician know that the downtrend is decelerating.

It’s important to remember that momentum measures the differences between prices at two time intervals. In order for the line to advance, the price gains for the last day’s close must be greater than the gains of ten days ago. If prices advance by only the same amount as ten days ago, the momentum line will be flat. If the last price gain is less than that of ten 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.

Because of the way it is constructed, the momentum line is always a step ahead of the price movement. It leads the advance or decline in prices by a few days, then levels off while the current price trend is still in effect. It then begins to move in the opposite direction as prices begin to level off.

The momentum chart has a zero line. Many technicians use the crossing of the zero line to generate buy and sell signals. A crossing above the zero line would be a buy signal, and a crossing below the zero line, a sell signal. However, basic trend analysis is still the overriding consideration.

Oscillator analysis should not be used as an excuse to trade against the prevailing market trend. “Buy” positions should only be taken on crossings above the zero line if the market trend is up. Short positions should be taken on crossings below the zero line only if the price trend is down. In future Technical Toolbox articles we will delve into some of the more popular momentum indicators such as RSI, CCI, stochastics and more. As an Optionetics trader, being able to accurately forecast future momentum and volatility is a huge advantage when implementing the variety of option breakout strategies we have in our arsenal.

Happy Trading.


Jeff Neal
Staff Writer & Options Strategist
Optionetics.com ~ Your Options Education Site
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