Momentum

Momentum

Momentum is a popular indicator that is used by many traders for various reasons. Momentum is calculated by measuring the amount that a security's price has changed over a given time period, i.e. the rate of change in the price. This value is plotted around a value of 100, and an example can be seen below.

For example if you are using a Momentum indicator with a value of 10 (i.e. you are measuring the amount the security has changed in the last 10 periods), and the value today was exactly the same as it was 10 periods ago, today’s momentum value would be ‘100’. If today’s closing price was $1.80 and it was $2.00 10 periods ago, today’s momentum value would be ‘90’.

Momentum indicators are used to primarily trade ranging markets. In a ranging market, price fluctuates up and down between support and resistance levels. Momentum indicators facilitate this process, because as price reaches the top of each swing, it tends to become overbought and as it reaches the bottom of each swing, it tends to become oversold. The indicator therefore tends to mimic the price.

This would not be of much use, except for two aspects of momentum indicators. First, momentum indicators tend to turn slightly before price. Second, it is often easier to see the deterioration of momentum in the indicator than in the price itself.

Momentum indicators are also useful in trading trends. They can be used to time the entry and exit from trends, and when you think about it, effectively, a trend is a sloping trading range. Naturally, most traders wish to follow the trend and enter a trade in the direction of the trend and hold that trade while the trend is intact. This can occur on one of two occasions.

First, a security may breakout of a trading range, therefore beginning a new trend. Alternatively, there may be an occasion when you will enter a trade in a trend that is already running strongly. The ideal entry for this type of situation is to enter on a correction or small retracement within the trend. Momentum indicators are an excellent tool for this purpose.

Momentum indicators are not as effective for exits as they are for entries. The main reason for this is that momentum indicators can be quite misleading because they go quickly to overbought in an up trend and oversold in a down trend. They can stay like that for a significant time as a trend takes time to develop.

The foundation of the success in momentum as an effective trading tool is the idea that if you can detect when a trend is losing momentum, you actually have a leading indicator of the potential deterioration and ending of a trend. Consequently, a leading indicator of this nature allows you the opportunity to act ahead of the crowd.