Momentum Explained: A Look At Overbought And Oversold Conditions

The term ‘Momentum’ is often used generically to describe a group of technical indicators that highlight extreme market levels; either overbought or oversold. The celebrity ‘A’ List of oscillators include the RSI, MACD, Price Oscillator and Stochastic measures. However, there is also a Momentum indicator in it’s own right.

Explanation
The Momentum indicator measures the velocity of a price move and is mercifully short on the maths. It’s measured by continually taking the price difference for a fixed time interval, say 12 days.

The basic formula is M=V-Vn

Where V is the latest closing price and Vn is the closing price n periods ago.

For Example
To construct a 12-day Momentum line, simply subtract the closing price 12 days ago from the latest closing price. This is then plotted around a zero ‘neutral’ line. If the latest price is higher than the price 12 days ago then it will have a positive value, plotted above the zero line. If the latest price is lower than the one 12 days ago; yep, you’ve guessed it. Then repeat on a daily basis.

This helps the trader to build up a picture of whether the trend is accelerating or slowing down. If the momentum line is rising then it means that the price is rising at a greater rate now than at the start of the period.

This indicator provides an early ‘heads up’ on a change in mood (sorry, it doesn’t work on women). The price might still be rising, but if the momentum line is flattening out, or falling, it’s a warning that enthusiasm for the trend is on the wane.

In effect, momentum is a lead indicator, but like all TA tools there are no guarantees. I only ever use oscillators as a warning, or an excuse to close a trade, but not as a trigger to open a new trade.

Where To Find The Momentum Indicator

On the chart, click on the ’settings’ box in the bottom left-hand corner. This will bring up the menu where you’ll find Momentum on the bottom half of the page. The box to the far right has a default setting of 12 periods, but feel free to stick your own number in. If you get bored you can stick a ‘14′ in the box and play Spot The Difference with the RSI chart.

The other box gives you a ‘percentage’ option, though I’ve never bothered.

Using Momentum To Trade

Overbought/ Oversold
The further the momentum line strays from zero the more overbought/oversold it is. As with the RSI this isn’t a reversal signal, but an amber warning to think about taking profits. But unlike the RSI indicator there are no upper and lower levels that numerically signal extreme overbought, or oversold levels. Levels need to be monitored relative to previous levels, instead of the ‘higher than 70′ or ‘lower than 30′ used with the RSI.

Crossing The Zero Line
Some traders use the zero crossover as their trade trigger. For example, if the momentum line crosses the zero line from negative to positive, traders will take that as a ‘buy’ signal. A cross below the zero line would trigger a ‘sell’ trade.

But, but, but, as with other oscillators the smart move is to only take the signals that go with the underlying trend, not the counter-trend signals. The honest chart above shows that this method is a bit hit and miss, and definitely requires work on finding a good confirmaion signal. There’s a separate article on finding trends but I generally use the 21-period moving average on my charts as a guide.

Divergence Indicator
Like the RSI this is when a price continues to rise, but the momentum is fading. For example, a bearish divergence occurs when the Momentum lines are well above zero and start to weaken, despite the price continuing to rise. This is flashing a big amber warning sign that the trend isn’t sustainable.

A bullish divergence occurs when the MACD lines are well below zero and start to rise, even though the price is continuing to fall.

Conclusion
So that’s a quick peek at momentum, more Anthea Turner than Carol Vorderman, but another option for your TA library. It’s uses are the same as the other oscillators mentioned at the beginning, but arguably in a more simple form. It’s not one I use, but perhaps that’s only because I got o RSI and MACD first; other traders might prefer this one. Give it a try; it might be the one for you.

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