Momentum

The Momentum indicator compares where the current price is in relation to where the price was in the past. How far in the past the comparison is made is up to the technical analysis trader. The calculation of Momentum is quite simple (n is the number of periods the technical trader selects):

• The current price minus the price n-periods ago

Hence, if the current price is higher than the price in the past, then the Momentum indicator is positive. In contrast, when the current price is lower than the price in the past, then the Momentum indicator is negative.

An example of the Momentum indicator is shown below in the chart of the E-mini Nasdaq 100 Future:

Potential buy or shortsell entries are shown above in the chart.

Momentum Buy Signal

When the Momentum indicator crosses above the zero line. The crossing of the zero line implies that the price of the stock, future, or currency pair is reversing course, either by having bottomed out or by breaking out above recent highs, a bullish signal.

Momentum Sell Signal

Momentum indicator crosses below the zero line. A cross of the zero line can generally mean two things: the future, currency pair, or stock's price has topped out and is reversing or that the price has broken below recent lows, either way, a bearish signal.

Momentum Exit Signals

Generally speaking the buy and sell signals discussed above are poor exits, either selling out of a long position or buying to cover a short position. By the time the Momentum indicator returns back to the zero line, most or all of the profits have probably eroded, or even worse the trader has let a winning position turn into a losing position.

When the Momentum is reversing course and is heading back towards the zero line, that means profits have been eroded. How much of a retracement back towards the zero line before an exit is triggered is up to the trader. Another alternative is to draw a trendline; when the trendline is broken, that could be the exit signal. Like most technical analysis indicators, interpreting them is part science, part art form.

Buy and sell signals are not the only use of the Momentum indicator. The next page discusses using Momentum to detect divergences, an important trading concept.

Momentum Divergences

Identifying divergences between price and technical indicators is important aspect of technical analysis trading. Bullish divergences can signal a trader to exit their short position; similarly, bearish divergences warn that prices could correct and it is advisable to exit any longs.

In the chart below of the S&P 500 exchange traded fund (SPY), Momentum divergences can be seen:

The first bearish divergence occured when price formed a double top formation. The Momentum indicator confirmed when price of the S&P 500 ETF failed to make a higher high.

The next divergence was a bullish divergence, where price made lower lows, yet the momentum indicator made higher lows. This signaled that the recent downtrend was losing steam and that a bottom could be forming.

The last divergence occured because the S&P 500 ETF was increasing, but at a decreasing rate. The momentum indicator shows this perfectly, by making lower highs over the course of about 15 stock trading days.

Just because a stock trader or futures trader sees a divergence doesn't mean that they should reverse their stock or futures trade. Divergences warn of potential reversals. A more concrete signal, like a trendline break would have been a great signal in the last example. Nevertheless, the Momentum indicator offered the stock trader plenty of time to reduce the size of their long stock position.

The Momentum indicator is a simple yet effective technical analysis tool, offering suggestions as to when to buy and sell and warning of potential price reversals. A similar, and arguably superior tool for measuring momentum is the Rate of Change indicator (see: Rate of Change).