Momentum indicators

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Momentum indicators are an important part of the technical analysis of share price movements. There are share traders who make a living by following and trading on momentum. Forget fundamentals, say such traders, what matters is whether a share price is moving or not.

Momentum at its most basic is a measure of the rate of ascent or descent of a share price. In other words, it is the rate of change that is important, rather than a share's absolute price level.

The simplest of momentum indicators is an easy thing to construct. It simply involves taking the price on any given day and subtracting the price a fixed number of days previously. Ten days is widely reckoned to be the optimum.

To introduce a little algebra into the mix, this can be represented as:

M = p - px

where px is the price 'x' days ago.

Performing this calculation on successive days and charting the result produces a line that will over time oscillate around zero. What's important here is to observe when the line changes direction, and particularly when it crosses zero, as this indicates first a faltering and then a reversal in momentum.

The advantage of momentum indicators is that generally when they show a reversal, say a faltering in upwards momentum, this will typically occur prior to a change in direction becoming apparent in the underlying share price.

Another way of measuring momentum is via the so-called rate of change indicator.

This simply changes to method of calculation from a straight subtraction to a percentage change, positive or negative. Hence:

ROC = 100 x (p/px)

This produces a similarly shaped graph to the one described above, but with the line oscillating around 100 rather than zero.

Many investors use pairs of moving averages, each taken over a different period of time, to give signals on buying or selling. A typical pairing might be to take 10-day and 40-day moving averages. Conventional wisdom suggests that the time to buy is when the 10-day average crosses the 40-day average from below when both averages are rising. This is known in technical analysis parlance as a 'golden cross' and is unequivocally bullish. The bearish equivalent, known as a 'dead cross', is when the 10-day crosses the 40-day average from above and both are moving down.

So far so logical, but in a momentum sense a much better visualisation from a timing standpoint can be gained by doing a so-called 'gap analysis'. This takes the difference in values between the two moving averages and plots it as a bar chart. A gap chart like this provides a much better analysis of changes in momentum and avoids the main criticism of the golden cross/dead cross approach. This is that it often gives signals only when it is, in practical terms, too late too profit from them, the move in price having already occurred by the time an investor can react.

The gap chart makes it possible to clearly identify when shares are overbought and oversold, which is essentially the object of the exercise for any momentum trader.

Momentum analysis can, however, also produce quirky results, particularly if a large price change occurs on one particular day, with much smaller changes on the days either side of it. This distorts the momentum indicator both on the day it occurs and also 11 days later (in the case of a 10 day momentum indicator) on the day it drops out of the calculation.

The solution to this is to use more sophisticated methods of calculation, which I'll deal with in a subsequent article.

Most good technical analysis software can deal with creating charts like this with ease, and that users can change the default values for performing the calculations to whatever number is wished. For example rather than calculate a 10-day momentum indicator, it is simplicity itself to define the indicator to calculate 12-day momentum, or whatever other value is required.

It is worth remembering, finally, that in thinly traded shares it does not take much to create an illusion of momentum. There have been instances of traders with big positions spreading false rumours in order to set up a share for a big momentum-induced rise (or fall).