One of the main goals of every trader using technical analysis is to measure the strength of an asset's momentum and the likelihood that it will continue. This is the primary purpose of indicators such as the moving average convergence divergence (MACD), stochastics, price rate of change (ROC) and the relative strength index (RSI).
Most of the indicators used to measure momentum are interpreted by using certain values that suggest the asset may be getting overbought or oversold. The strength of current momentum is considered to be getting weaker when indicators such as the ones mentioned above have values that demonstrate overbought or oversold conditions. For example, many traders suggest that an asset with an RSI below 30 or a stochastic value below 20 may experience a reduction in the amount of downward momentum and is a likely candidate for a reversal.
You may notice that many momentum indicators are bound between two extreme levels, usually 0 to 100 or -100 to +100. This is important because a cross through the center line of the indicator is interpreted to mean that momentum is either increasing or decreasing, depending on the direction. For example, momentum is said to be increasing when the ROC indicator crosses above the 0 line, and decreasing when it crosses down through 0.
To dig a little deeper into this particular technical indicator, rate of change is the speed at which a variable changes over a specific period of time. It can generally be expressed as a ratio between a change in one variable relative to a corresponding change in another. Graphically, the rate of change is represented by the slope of a line, or horizontal median called the equilibrium. It is this median that tells us everything we need to know about rate of change.
The normal time frame for ROC measurement is 10 days. The ratio to build the ROC indicator is as follows: Rate of Change 100 (Y/Yx).
"Y" represents the most recent closing price, and Yx represents the closing price a specific number of days ago. So, if the price of a stock closes higher today than it did 10 days ago, the ROC value point will be above the equilibrium, thus indicating to chartists that prices are rising in that particular issue. Conversely, if the price in today's session closes lower than it did 10 trading days ago, the value point will be below the equilibrium, indicating that prices are falling off. It is safe to say that if the ROC is rising, it gives a short-term bullish signal, and a bearish sign would have the ROC falling. Chartists pay great attention to the time period in the calculation of ROC. Long-term views of the market or a specific sector or stock will use perhaps a 26- to 52-week time period for Yx and a shorter view would use 10 days to around six months.
In addition to ROC and the other methods we've already mentioned, traders can also monitor the crossing of certain moving averages to confirm the strength of a price move. Momentum is said to be increasing when a short-term average crosses above a longer-term average. This is the premise behind the MACD indicator, which uses a 12-day exponential moving average and a 26-day EMA. When this indicator has a value greater than 0, it means that the shorter-term average is above the longer-term average, and it may suggest that momentum is increasing.
To learn more about momentum trading, see Introduction to Types of Trading: Momentum Traders and Momentum Trading With Discipline.