Making the Momentum Indicator 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. This market "momentum" is a key indicator regarding the strength of a trend, or whether a trend is about to end or begin.

When I worked as a market reporter on the trading floors of the Chicago Board of Trade and the Chicago Mercantile Exchange, I (as well the floor traders) had a very keen sense of which camp (bulls or bears) had momentum on their side. This was especially true in the grain pits at the Board of Trade. One obtained this keen awareness by being right on the trading floor, talking with all the market-makers who helped determine prices.

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 have to be employed. One such technical tool is the Momentum indicator.

The Momentum indicator is a popular technical study. It is easy to calculate and can be applied in various ways. Momentum can be calculated by dividing the day’s closing price by the closing price "X" amount of days ago and then multiplying the quotient by 100.

The Momentum study is an oscillator-type that is used to interpret overbought/oversold markets. It assists in determining the pace at which price is rising or falling. This indicates whether a current trend is gaining or losing momentum, whether or not a market is overbought or oversold, and whether the trend is slowing down.

Momentum is calculated by computing the continuous difference between prices at fixed intervals. That difference is either a positive or negative value, which is 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.

You specify the length of the momentum indicator. 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 particular commodity you are trading.

Like most other "secondary" trading tools in my trading toolbox, I do not use the Momentum indicator, solely, 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 by using my "primary" trading tools, such as trend lines, chart patterns and fundamental analysis.