Momentum Oscillator

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Introduction

The Momentum Oscillator is used to calculate an asset’s change in price over a specific time frame.  Faster rates of change can signify higher levels of strength in a price movement and when the indicator shows that momentum is building in a bullish (or bearish) wave, positions can be established positions and be viewed with a higher level of credibility.

Generally, the Momentum indicator will show a comparison between the closing price of the current interval with that of the previous interval but there are other applications as well, with many traders using the indicator to plot rates of change in other indicators (for example, RSI or moving averages). High momentum levels (which can be positive or negative) show us that a strong trend is in place (bullish or bearish), while low levels of momentum shows us that the current price direction is near completion.

Two Common Methods

The Momentum Oscillator is generally used in two ways, as a means for identifying underlying trends or as a leading indicator to spot overbought and oversold trading conditions. The value of this information is that it allows traders to spot areas when trends are beginning to weaken (forecasting a reversal). Conversely, the indicator enables us to easily spot trends that are building and likely to continue. Many inexperience traders overlook the Momentum Oscillator, as it looks relatively simplistic but as part of a larger trading strategy, this indicator can prove valuable in spotting trade entries (and exits) and help to confirm signals generated by other chart formations.

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Trade Signals

Typically, different types of signals are generated when market behavior changes.  Specifically, the signals seen during range bound markets will differ from those seen during trending markets.

During range bound markets, overbought and oversold levels must be established. These levels are based on historical averages and will help us to when buying and selling activity becomes overextended. “Buy” signals can be seen when the indicator dips into oversold territory and then crosses back above it. “Sell” signals can be seen when prices reach overbought territory and then roll back below it.

Another strategy is to use “divergences” to forecast future price activity. In this case, indicator activity “diverges” from price activity and indicates a potential reversal. A bullish divergence occurs when indicator troughs trend upward while prices are in decline. Bearish divergences occur when indicator peaks trend downward while prices are rallying.

In trending markets, we identify the underlying momentum by looking at the indicator’s position relative to the zero-line. Uptrends show momentum above the zero-line, while downtrends show momentum below the zero-line. Since trend traders look to capitalize on the underlying momentum (as opposed to contrarians, who look for reversal points), the momentum indicator will generate long positions when the indicator moves above the zero-line. Short positions should be taken when the indicator reading is seen below the zero-line.

Calculations

The simple equation for the Momentum Oscillator is as follows:

Momentum = (Closing Value / Previous Closing Value) x 100

Essentially, when the current value is higher than the previous value, Momentum is positive. When the current value is seen lower, Momentum is negative.

Exit Signals

Finally, the Momentum Oscillator can be used as a means for determining when trades should be closed.  In the process of any trade-making decision, we need to have clear values to determine stop loss levels and profit targets and one way of doing this can be seen when the underlying momentum starts to turn against the position.

There is little reason to hold a long position, for example, if the Momentum Oscillator crosses below the zero line (signifying downward momentum). In some cases the indicator will diverge from the price activity and this can allow traders to exit the position (maximizing profit and limiting losses) before the adverse movement actually occurs. With this in mind, the Momentum Oscillator should be seen as a tool, not only for entering into new positions, but also in making the decision to close positions that are already established.

Conclusion

In conclusion, the Momentum Oscillator is a widely used tool in technical analysis, which allows traders to easily identify the underlying price pressure (momentum) in a given asset. Though it is often overlooked by new traders, its applications are numerous and varied, enabling traders to identify both entry and exit levels. Trades can be based on internal price strength (or weakness) and can be used in both range bound and trending markets.