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The momentum indicator is considered a technical tool that determines the strength and direction of the trend and additional tools for market development. Momentum indicators are used to analyze any market: Forex market, stock market, commodity market, and cryptocurrency market. The momentum indicator has proven to be very effective in long-term trading strategies, but it can also be applied to short-term trading.
The momentum indicator was developed by the gifted French mathematician Paul Émile Abel, who is known for his discoveries in the fields of analysis, mathematics, geometric engineering, and mechanics. He authored over one hundred books, earned a PhD in mathematics, and was elected a member of the French Academy of Sciences.
The famous trader Martin Pring is one of the most well-known proponents of the momentum indicator. He has been conducting comprehensive analysis of technical tools and indicators for many years. His market predictions are based on a long-term economic model that lays the foundations for applying technical tools. Pring's books on market analysis rely on using the concept of the momentum indicator as an additional tool for market entry signals.
What does momentum trading (MTM) mean in stocks? Definition and meaning
The momentum indicator or MTM (Momentum Trading Indicator) is used to analyze trend direction and strength and to determine potential pivot points.
The momentum trading indicator is a simple leading indicator with a very clear reading. If the indicator rises and remains above some moving averages, then the trend is upward. If the indicator is low and remains below the moving averages, then the trend is downward.
The momentum indicator compares the last closing price with the previous closing price n periods ago and shows the results numerically, where the momentum trader determines whether buying is profitable or selling, what the potential profit for trading is, and whether the trend should reverse soon.
Many traders consider the momentum indicator as an oscillator, but it is not precise. The momentum trading indicator can be used as both an oscillator and a trend indicator.
The momentum indicator is often used in stock trading on the daily chart to determine the current financial position of the market, trend strength, and price direction. The momentum indicator is frequently used by stock traders as a supplementary tool to filter market entry signals. The main idea is that the indicator readings should align with news related to the company's performance.
How does the momentum indicator work?
The indicator compares the current closing price with the closing price n periods ago, where the results appear as a dashed line on the chart. The indicator readings form the main points on the chart, the highs (peaks) and lows (troughs) that can be easily seen. By analyzing these extremes (peaks and troughs), the trader decides how to use the momentum indicator:
If the indicator line is above the zero line, the trend is upward. If the indicator line is below the zero line, the trend is downward.
If the momentum indicator shows a very high or low level, the current trend should continue.
If the price shows the next increase is higher than the previous one, and the momentum indicator level is high and below the previous high, the ongoing uptrend may be exhausting, weakening the momentum indicator, and the price may begin to decline soon.
If the price chart shows the next decline is less than the previous one, and the decline in the momentum indicator is higher than the previous level, then the ongoing downtrend may be exhausting, weakening the momentum indicator, and a correction or trend reversal should start soon.
Note: The last two cases are called 'divergence and convergence,' where the momentum indicator acts as an oscillator in such cases. It should be noted that the trend can continue after slowing down, so other tools should be used to confirm divergence signals.
How does the momentum indicator work?
Momentum indicator calculation equation
There are several equations to calculate the momentum indicator. The most common is the one mentioned by John J. Murphy in his book Technical Analysis of Financial Markets, where he calculated the momentum value as the difference in closing prices for current and past periods (a specified number of previous period columns):
M(j) = CLOSE(j) – CLOSE(j – n), where
M(j) - is the momentum reading;
CLOSE(j) — is the last closing price or most recent closing price;
CLOSE(j – n) — is the closing price n periods ago.
This equation shows that the momentum indicator is the difference between the last closing price and the closing price n periods ago. The trader independently determines the factor n in the indicator settings. Default values for n are often set at 10 or 14, and the indicator value is often calculated at 21.
According to the equation advised by John Murphy, the momentum indicator reading can be positive or negative.
Some traders consider that the value of the indicator, which fluctuates around 0, is not very suitable, so Steve Achilles mentioned in his book Technical Analysis from A to Z the following momentum indicator calculation equation:
M(j) = CLOSE (j) * 100 / CLOSE (j – n), where
M(j) — is momentum;
CLOSE(j) — is the last closing price;
CLOSE(j – n) — is the closing price n periods ago.
The difference between the first version and the second version of the equation is that the indicator is expressed in relative terms and its readings fluctuate not around zero, but around level 100. It does not matter which equation should be used.
How can the momentum indicator be read?
The primary function of this indicator is to determine the direction of the price trend. Let's take a look at the times when trend acceleration and deceleration occur.
Imagine that the market suddenly moves strongly up or down. This may be due to traders reacting to news releases or as a result of significant manipulation by a large trader (with huge trading volume). Regardless of the reason, this movement is called 'impulsive movement or momentum.'
Price momentum on the chart indicates that the trend is accelerating. The momentum indicator will rise. However, when the trend slows down, the momentum indicator readings will decline.
Momentum in trading is the rate of change of an asset's price over a specified period:
The faster the current price increases, the greater the momentum value increases.
The faster the current price decreases, the greater the momentum value decreases.
Momentum Indicator: Description and Application. Main Features and Drawbacks:
If the momentum indicator is above level 0, the trend is upward.
If the momentum indicator is above level 0 with increasing readings, the uptrend is accelerating. This means that the current uptrend is strong, and the price should continue to rise.
If the momentum indicator begins to decline but remains above level 0, the trend remains upward, with a slowdown in price growth over the long term. This means the uptrend is exhausting, but the trend may not reverse.
If the momentum indicator is below level 0, the trend is downward.
If the momentum indicator is below level 0 with decreasing readings, the downtrend is accelerating. This means that the current downtrend is strong, and the price should continue to fall.
If the momentum indicator begins to rise but remains below level 0, the trend remains downward with a slowdown in price decline. This means the downtrend is exhausting and may not reverse.
Potential momentum signal for buying
When the momentum line crosses the zero level upward, this gives a potential buy signal. This means that the price of ordinary stocks, futures, or currency pairs begins an upward trend or upward correction.
Potential momentum signal for selling
When the momentum line crosses the zero level downward, this gives a potential sell signal. This means that the price of ordinary stocks, futures, or currency pairs begins a downward trend or downward correction.
Potential momentum exit signals
When the momentum indicator returns near level zero, this gives a potential exit signal. But if exiting a trade relies solely on such a signal, you might miss out on a significant portion of potential profit or incur a loss.
To avoid this, some traders focus on how much the indicator has risen or fallen compared to previous data. If the indicator line drops deeply, this is the right time to take profits from a sell trade. If the indicator line rises significantly above level 0, this is the right time to take profits from a buy trade.
An alternative exit signal is when the indicator crosses its trend line. Once the trend line is broken in the opposite direction of the trade direction, this is the right time to close the trade.