Momentum
Adrian Aquaro
April 7, 2005

Momentum is a traditional indicator, and it has been used around 3 decades by most of analysts and investors. Despite of several seminaries and debates about this instrument, only a few traders could see its real value when they have to trade.

So, at first, we will describe it:

Momentum is an open indicator since its formula doesn’t contain percentage. A simple definition of Momentum could be a line which oscillates with a central axis, mediatory line in number "100", nevertheless it will not have bands that limit their morphology.

Its formula is the following one:

M = C(today) - Cn

Where: M: Momentum, C today: it closes (of the session that we are analyzing) Cn: it closes of the first session for the registered period (Example: C14 is the daily close for the last 14 days).

It is "an advanced" indicator. Which is the true mean of this expression?

We understand that is given by the impact of the difference between the two significant sessions close and the last one, and we will take, as a reference for this session, a 14 day close period.

Then we will obtain a consequence differential between this indicator and those that need to calculate averages or several averages in their formula. The interpretation is the following:

The data "advanced" or leader, is that the last close this by above or below the closing of the session witness.

This information will give us a certain situation of market, but we cannot analyze it, because its formula has not average, and take only actual close vs. past close. So, from that moment and successively, momentum will show the behavior of that vector, bull or bear.

Acceleration:

Another interesting approach is the concept of speed or acceleration that shows this indicator. J. Welles Wilder Jr, has explained it clearly and under his interpretation we will define the "acceleration" with the following example:

Let’s suppose that the Euro has closed today one point over the 14 days ago close, for example 1,3000, today close is 1,3030.

Momentum will show acceleration if the difference between today close and the following close is over 30 points, for example, 1,3062. Why 30 points? Because difference between first close and second close is 30 points. If you take a bear rally, momentum will work the same way. Let’s see the first example:

Fig. 1

Fig. 2

If we observed the differences of vectors (C Today - C14) there will be acceleration of the curve of the indicator with greater differences between last close and actual close, are and deceleration when that difference is smaller to the previous one.

Convergence - Divergence:

As we always say, different indicators are a filter of the behavior of price curve, and Momentum is not an exception. Momentum is a powerful tool to anticipate what price curve will do. We can say that the relation that exists between the price and the indicator will be coordination or convergence (fig. 3), which means the union of maximums or relative minimums within them chart and the line of indicator with identical direction. That also means that principal trend is strong. Also, divergence shows important interpretations that will be useful, and will be so important when you trade.

Fig. 3

Fig. 4

We observed In Fig.4 two divergences A-B and B-C: the first one anticipates that a maximum relative in short direction hits in the indicator locating it in the zone of the maximum. To previous and the Maximum of price C, is interpreted by the indicator like a minimum respect B which indicates a clear anticipation of a direction change.

Now, let´s see over bought and over sold zones

Fig. 5

As we said before, Momentum is an open indicator, so over bought or over sold zones are limited at the moment in relation to the antecedents of the line action: In the illustration we have two maximums 1 and 2. Soon, we drew up a line that “touch” those maximums or the minimums (these are - 1 and – 2), and then, we see that price re enter in trade zone, but before, price enter in over bought zone. This happens in over sold zone, with -1 and -2 points. So, a good trade strategy can be to trade bear when price re enter in trade zone from over bought zone, and to trade bull when price re enter from over sold zone.

Trigger: We said that middle line in Momentum is “100”, and, when momentum line crosses “100”, you have an excellent trigger to trade. Also, "100" is a support and dynamic resistance of price action.

Fig. 6

Relation with other tools:

Alexander Elder, in his book "Trading for a living" proposes to combine this signal with an moving average body as a filter of the trade. We usually use a simple moving average of 21 sessions. As well as it is seen in the example for the Euro, the indicator on 100 and price upon the average is a trigger. Trader College recommends to try and test this trigger in demos. Also, you can draw up trend lines in charts combined with momentum trend lines.

Fig. 7

In previous chart, EUR/ USD 4 hrs. 03/02/05 - 05:00 hrs, you can see a clear trade:

Momentum and chart trend lines are broken, and you have a trigger there. Also, price is over 21 sessions SMA.

(Adrian Aquaro is a Principal of www.tcollegeweb.com and is an expert in the area of Technical Analysis.)

Any comments and queries can be sent through our web-based form.

More Brownian Motion>>

back to top