How can Momentum Indicate Stock Price Strength?

Momentum is the speed or velocity of price changes in a stock, security, or tradable instrument. Momentum shows the rate of change in price movement over a period of time to help investors determine the strength of a trend. Stocks that tend to move with the strength of momentum are called momentum stocks.

Momentum is used by investors to trade stocks in an uptrend by going long—or buying shares—and going short—or selling shares—in a downtrend. In other words, a stock can be exhibit bullish momentum, meaning the price is rising, or bearish momentum where the price is steadily falling. Since momentum can be quite powerful and indicate a strong trend, investors need to recognize when they're investing with or against the momentum of a stock or the overall market.

Understanding Momentum

Momentum measures the rate of the rise or fall in stock prices. For trending analysis, momentum is a useful indicator of strength or weakness in the issue's price. History has shown that momentum is far more useful during rising markets than falling markets because markets rise more often than they fall. In other words, bull markets tend to last longer than bear markets.

Momentum is analogous to a train whereby the train slowly accelerates when it starts moving, but during the ride, the train stops accelerating. However, the train moves but at a higher velocity because all of the momentum built up from accelerating is propelling it forward. At the end of the ride, the train decelerates as it slows down.

In the markets, some investors might get in and buy a stock early while the price is beginning to accelerate higher, but once the fundamentals kick in and it's clear to market participants that the stock has upward potential, the price takes off. For momentum investors, the most profitable part of the ride is when prices are moving at a high velocity. Of course, once the revenue and earnings are realized, the market usually adjusts its expectations and the price retraces or comes back down to reflect the financial performance of the company.

Calculating Momentum

There are many charting software programs and investing websites that can measure momentum for a stock so that investors don't have to calculate it anymore. However, it's important to understand what goes into those calculations to better understand what variables are used in determining a stock's momentum or trend.

In his book, "Technical Analysis of the Financial Markets," author John J. Murphy explains:

"Market momentum is measured by continually taking price differences for a fixed time interval. To construct a 10-day momentum line, simply subtract the closing price 10 days ago from the last closing price. This positive or negative value is then plotted around a zero line."

The formula for momentum is:

Momentum=VVxwhere:V=Latest priceVx=Closing price\begin{aligned} &\text{Momentum}=V-Vx\\ &\textbf{where:}\\ &V = \text{Latest price}\\ &Vx = \text{Closing price}\\ &x = \text{Number of days ago} \end{aligned}Momentum=VVxwhere:V=Latest priceVx=Closing price

Measuring Momentum

Technicians typically use a 10-day time frame when measuring momentum. In the chart below, momentum is plotted for the price movements of the S&P 500 Index, which is an excellent indicator of the trend for the overall stock market. Please note that for illustrative purposes, the chart below is only the momentum for the S&P and excludes the prices from the index.

If the most recent closing price of the index is more than the closing price 10 trading days ago, the positive number (from the equation) is plotted above the zero line. Conversely, if the latest closing price is lower than the closing price 10 days ago, the negative measurement is plotted below the zero line.

The zero line is essentially an area where the index or stock is likely trading sideways or has no trend. Once a stock's momentum has increased—whether it's bullish or bearish–the momentum line (yellow line) moves farther away from the zero line (blue line).

Without looking at the price of the S&P and only using momentum, we can see that it's likely the S&P index rallied in tandem with the spikes above zero on the momentum indicator below. Conversely, it's likely the index fell on the large downward moves below zero.

Momentum Example S&P 500
Momentum Example S&P 500.  Investopedia

If we overlay the price of the S&P 500, along with momentum, we can see that the index corresponds or correlates fairly well with moves in momentum.

  • In the summer of 2016 (the left-hand side of the chart), we can see that momentum was choppy (blue box) while the S&P 500 traded sideways.
  • In September of 2017, we can see that both momentum and the S&P broke out (blue arrows) rallying whereby the S&P eventually touched 2875.
  • In January and December 2018, momentum began collapsing and fell below zero (pink arrows) taking the S&P with it lower.
  • The market rallied in early 2019 whereby momentum turned bullish again breaking above zero, while the S&P raced higher to ~3030.
S&P Price and Momentum Chart
S&P Price and Momentum Chart.  Investopedia

From the chart above, we can see that if momentum is above zero, but not trending higher, it can lead to the S&P's price falling eventually—as in the case of May-through-September 2019 (in between the two pink arrows). Many investors and traders watch the moves in momentum and the S&P because if the two are not moving in sync, something's askew. In other words, either the S&P or momentum needs to adjust.

Special Considerations

When the momentum indicator slides below the zero line and then reverses in an upward direction, it doesn't necessarily mean that the downtrend is over. It merely means that the downtrend is slowing down. The same is true for the plotted momentum above the zero line. It may take a few moves above or below the zero line before a trend is established.

It's important to note that many factors drive momentum. Economic growth in the economy, earnings reports, and the Federal Reserve's monetary policy all impact companies and whether their stock prices rise or fall. In other words, momentum isn't a predictor of price movement, but instead, reflective of the overall mood and fundamentals of the market. Also, geopolitical and geofinancial risks can drive momentum and money into-or-away from stocks. Although it's helpful for investors to understand the market's momentum, it's also important to know what factors are driving momentum and ultimately price movements.

The Bottom Line

Momentum is a good indicator for determining price movements and subsequent trend development. However, like most financial indicators, it's best to combine momentum with other indicators and fundamental developments when evaluating trends in the markets.