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. Momentum measures the speed at which the price of a security is moving, and there are a variety of indicators one can look at to measure this.
Most of the indicators used to measure momentum are interpreted by using certain values that suggest the asset may be getting overbought or oversold, which is a weakening of momentum, and would signal a reversal in the trend.
Momentum indicators are bound between two extreme levels. This is important because a cross through the center line of the indicator is interpreted to mean that momentum is either increasing or decreasing and that acts as an indicator to buy or sell.
Some of the main tools to measure momentum are the moving average convergence divergence (MACD), stochastics oscillator, price rate of change (ROC) and the relative strength index (RSI).
Moving Average Convergence Divergence (MACD)
The MACD depicts the relationship between two moving averages of a security's price. It is calculated by subtracting the 26-month exponential moving average from the 12-month exponential moving average. When this is calculated, an MACD line is created and a nine-day MACD line, known as the "signal line," is transposed over the MACD line. This then functions as a trigger to buy or sell depending on where the MACD crosses the signal line.
Rate of Change
The rate of change is the speed at which a variable changes over a specific period of time. It is 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 and mathematically as the percentage change in value over a specific period of time and represents the momentum of a variable.
To calculate the ROC, one takes the current value of a stock and divides it by the value from a previous period, then subtracts one and multiplies by 100 for the percentage figure.
Rate of Change = [(Current Value of Stock/Previous Value of Stock) - 1]*100
A security with a high momentum has a positive ROC and outperforms the market in the short term whereas a low momentum security has a negative ROC and is likely to decline in value, which can be seen as an indicator to sell.
The stochastic oscillator seeks to measure the closing price of a security to a range of its historical prices over a defined period of time. It is used to generate overbought and oversold trading signals using a 0–100 bounded range of values. Values over 80 are considered to be in the overbought range and values below 20 are considered to be in the oversold range. When values reach these points they typically indicate a reversal of the trend.
Relative Strength Index (RSI)
The RSI measures the magnitude of recent price changes. The RSI looks at average gains or losses over 14 trading periods. Much like the stochastic oscillator, it uses a bounded range value of 0-100 to mark overbought or oversold conditions in the price of an asset. Values that are 70 or above indicate an overbought security where values of 30 and below indicate an oversold condition.