Tuesday, June 28, 2011

The Momentum Indicator

Momentum measures the amount that a price has changed over a given time span. The ratio is calculated by the following formula:
Momentum = (C/Cn)*100

where C is the most recent closing price, and Cn is the closing price n periods ago.

Trend followers buy when the momentum indicator bottoms and turns up, crosses above some absolute threshold, crosses above some moving average of itself, or shows some positive divergence relative to price. Trend followers would sell when the opposite conditions apply.

Divergences between momentum and price can be a leading indicator. As prices enter an important Top Reversal Pattern, momentum begins to deteriorate as the advance slows. Similarly, at a market bottom, momentum often stabilizes before price. The velocity of price movement is a leading indicator of a change in trend direction.

It's important to note that momentum precedes price. Therefore, momentum hits its peak well before the price hits its ultimate high. Momentum decreases more dramatically as price rallies begin to fall short of previous peaks on minor rally attempts, depicting a very mature phase of bullish exhaustion.

The chart above is the intraday stock chart for Ford. The indicator shown is the 10 period Momentum on a 5-minute Ford chart. Between 11AM and 12PM, you can see that Ford made a new low in price, but a higher high in momentum. A savvy trader would use this divergence to cover short positions. Between 1PM and 2PM, Ford made a new high in price, but an equal high in momentum, resulting in bearish divergence. A savvy trader could use this to exit long positions. 


 *Special thanks to Option Radar, BMO Capital, MEB Options, LiveVolPro, CBOE, Option Monster, T.O.P. group, and all of the options desks and traders we work with to provide the option flow!

 No position at this time. Position declarations are believed to be accurate at time of writing but may change at any time and without notice.

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