Investment Lessons - Lesson 6 - Technical Analysis

Momentum

Momentum is the measure of rate of change in prices.

As true in investing as it is in physics, bodies in motion tend to remain in motion.

And, like in physics, when the body in motion strikes something, the momentum, or motion, slows or stops.

If there were a way to determine this momentum, it would provide a valuable tool in predicting price movements.

Welcome the momentum oscilator.

It is easy to calculate, highly visual in interpretation, it helps to signal price direction.

We’ll use the same data and chart for the Dow Jones 30 Industrials that we had for the lesson on MACD. To that chart, we have added a new section for momentum.

Calculating momentum isn’t difficult. Simply divide today’s price by the price 10 days ago. The result is today’s momentum number, and it is plotted on the chart.

Also on the chart is a horizontal line drawn at 100, which represents equilibrium of momentum. Equilibrium of 1 or as it is charted: 100, would in effect mean that there was no change in the price from 10 days ago, and thus no market momentum.

The signals for entry and exit then are: buy, or enter, when equilibrium is rising and sell, or exit when momentum is declining. In general, if the momentum line is greater than 100, the market is positive. Conversely, the market is negative when momentum is below the 100 line.

One important factor to remember. Momentum is a leading indicator, meaning it will diverge before most of the other indicators. By watching momentum, you can be alert for other confirming signals of changes in prices from our other indicators.

The more confirmations one receives, the greater the validity of the movement in price.

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On March 21, the Momentum oscillator broke sharply up four trading days before the MACD turned positive. From that point, you would have two confirming signals for market entry. Even though the 50 day moving average was below the 200 day, those two signals would have had a participant enter the market, which would have allowed upside from 9,400 level to over 11,000.

The most important thing for you to remember in all of our lessons: Confirm the price action with more than one indicator. No single indicator can give absolute market turning points. Combinations of indicators, however, can give you an excellent roadmap to where the market is headed.