Weekly Insights: Making the Momentum Work for You
Making the Momentum Work for You
When analyzing markets, I often use the term “momentum” when referring to the amount of strength the bulls or bears have at a given point in time. As a market reporter on the trading floors of the Chicago Board of Trade and the Chicago Mercantile Exchange, I had a very keen sense of which camp had momentum on their side, as did the floor traders. This was especially true in the grain pits at the Board of Trade.
By examining charts, cycles, seasonality, and other technical indicators — and near-term fundamentals — one can also get a good reading on whether the bulls or the bears have the edge in any given market. However, I must admit that when trying to gauge market momentum there is no substitute for working right on the trading floor and talking face-to-face with the market-makers. But very few get that opportunity, so other tools must be employed. One such technical tool is the momentum indicator.
Momentum is a popular technical study that can be applied in various ways. One example of its use is to interpret overbought/oversold markets and to assist in determining the pace at which price is rising or falling — whether a current trend is gaining or losing momentum and whether the trend is slowing down. It is calculated by computing the continuous difference between prices at fixed intervals: Divide the day’s closing price by the closing price “X” from a number of days ago, then multiply the quotient by 100. That difference is either a positive or negative value, which is then plotted around a zero line. When momentum is above the zero line and rising, prices are increasing at an increasing rate. If momentum is above the zero line but is declining, prices are still increasing but at a decreasing rate.
The opposite is true when momentum falls below the zero line. If momentum is falling and is below the zero line, prices are decreasing at an increasing rate. With momentum below the zero line and rising, prices are still declining but at a decreasing rate.
The normal trading rule is: Buy when the momentum line crosses from below the zero line to above. Sell when the momentum line crosses from above the zero line to below. Another possibility is to establish bands at each extreme of the momentum line. Initiate or change positions when the indicator enters either of those zones. You could modify that rule to enter a position only when the indicator reaches the overbought or oversold zone and then exits that zone.
It is you who specifies the length of the momentum indicator, and you must determine a value suitable to your trading needs and methods. Some technicians argue the length of the momentum indicator should equal the normal price cycle. The best method is to experiment with different lengths until you find the length that works best for that commodity you are trading.
Like most other “secondary” trading tools in my trading toolbox, I do not exclusively use the Momentum indicator to generate buy and sell signals, or to gauge the overall technical situation in a market. I use the Momentum indicator to help confirm or refute general ideas I have developed through the use of my “primary” trading tools, such as trend lines, chart patterns, and fundamental analysis.
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