Momentum is perhaps the simplest and easiest oscillator (financial analysis tool) to understand and use. It is the measurement of the speed or velocity of price changes, or the rate of change in price movement for a particular asset.
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:
V = latest price
Vx = closing price
x = number of days ago
The Basics of 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. (For more, see Momentum Trading with Discipline.)
Momentum is a lot like a train. The train accelerates but moves slowly when it starts. During the ride, the train stops accelerating but moves at a higher velocity. At the end, it decelerates as it slows down. The best part for momentum investors is the middle, when prices are moving at a high velocity.
Technicians use a 10-day time frame when measuring momentum. The chart below shows a zero line. If the most recent closing price of the stock 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.
Measuring the price differences over a set period shows the rates at which the stock price is rising or falling. Momentum shows trendlines. Distinct trendlines develop as the stock price increases, and a rising momentum plot line above zero indicates an uptrend is firmly developing. A plotline starting to level off indicates to technicians that the latest price of the stock is about the same as it was 10 days ago. Thus, the velocity of the trend is slowing. The reverse is also true. (For related reading, see Riding The Momentum Investing Wave.)
When the momentum indicator slides below the zero line and then reverses in an upward direction, it does not 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.
Figure 1: Microsoft Stock Data February 2001 - August 2001
In Figure 1, a very clear trend develops in mid-March. Over the next five weeks, the stock price moves in an extremely strong momentum from about $50 all the way to $72 and $73. A two-line simple moving average over the same period of time would show a clear crossover, indicating a strong buy entry point.
The Bottom Line
Momentum is a good indicator for determining price movements and subsequent trend development, but it must be used with other indicators to be an effective buy/sell indicator. (To learn more about momentum, read Momentum and the Relative Strength Index.)