The Momentum Indicator is an oscillator which stands for the acceleration rate of the price movement. In other words, Momentum refers to the rate of change of particular asset for the defined period – is the velocity of price change.
Despite its simplicity Momentum Indicator embodies important meaning for the traders. The main principle of Momentum Indicator:
- The Momentum Indicator oscillates around the 100 line. If it is above 100 level, the price has risen since the last N bars; if the momentum indicator is below 100 level, the price has fallen since the last N bars.
- Even if it is considered an oscillator, the maximum values are not limited. There no fixed max-min range, price action over the last N bars dictates the indicator values.
Overall, Momentum measures the rate of the rise or fall in the asset price. There is a widespread belief, which came from stock trading, that Momentum Indicator is more accurate during bullish periods than during falling markets; the fact that markets rise more often than they fall the reason for this.
Momentum Indicator is the basis of well-known indicators, such as RSI.
J. Welles Wilder was one of the first to publish information about using a Momentum Indicator to play the financial markets in his book New Concepts In Trading Systems.
Momentum is calculated as a ratio of current price to the price N periods ago
MOMENTUM = CLOSE(i)/CLOSE(i-N)*100
CLOSE(i) — is the closing price of the current bar;
CLOSE(i-N) — is the closing bar price N periods ago.
In contrast to the RSI and Stochastic strategies, Momentum is usually underlies trend following strategies. If the asset is trending down, one takes a short position. Instead of the traditional approach – buy low, sell high – Momentum traders tries to sell low and buy lower, or buy high and sell higher.
Nevertheless, trend reversal strategies are possible; the only difference is that traders should wait for the confirmation after indicator shows turnaround point.
Momentum Indicator can serve as a trend-following oscillator similar to the MACD Indicator. The rules are Buy when the indicator bottoms and turns up and sell when the indicator peaks and turns down. Since Momentum does not have fixed range, it is necessary to plot a short-term moving average of the indicator to determine bottoms and picks.
There will be false signals, so one should consider some confirmation system. One of such situations is if the Momentum Indicator reaches a peak much higher than previous values. In such case, one should assume a continuation of the current trend rather than reverse movement. For example, if the Momentum indicator reaches extremely high values and then turns down, the trader should assume prices will probably continue to grow. In either case, the trader should wait for the confirmation signal. (e.g., if prices peak and turn down, wait for prices to begin to fall before selling).
Positioning indicator about the 100% level is necessary. Due to the principals of calculation of the Momentum Indicator, 100% level stands for the pivotal point between uptrend and downtrend. Therefore, if indicator crosses 100% level from above – down it is considered as a start of the downtrend movement, crossing from below – up is the beginning of the upward trend.
The graph clearly shows that the indicator gives a lot of false signals during periods of low volatility.