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
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.
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.
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.
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.