Momentum Oscillators (1): Basic Definition
In order to succeed in any investment or trading, be it buying a security or opening a restaurant or having a share in a local ice-cream store, you have to know exactly what you are doing instead of simply relying in a number of a set of numbers.
In this article we are going to look at the momentum oscillators. My belief has always been that in order to use an indicator/oscillator properly, you need to truly understand what it is and how it is computed and what it means practically (and that is different from how to use it magically). You cannot use any indicator as a magic tool as in buying or selling if the momentum is above or below a certain value. There is no such magic number. Each tool must be used with proper understanding.
Definition and Calculation of Momentum
Momentum is a simple oscillator. It comes in two forms: difference and ratio. In the difference form the oscillator is often know as Rate Of Change (ROC). It is calculated by subtracting the price of N periods ago (for example, 7 days ago) from the last closing price.
The term rate-of-change (ROC) is actually better than momentum. The calculation of momentum shows that it is simply the velocity, speed or literally rate of change of the price of the security. In physics momentum is a product of velocity and mass. A truck hitting you at 50 mph is going to have an impact different than a cotton ball hitting you at the same speed, and that is because the mass of a truck is much higher than that of a cotton ball, and so the momentums of the two are different. The momentum known as ROC is simply a speed and so it is misleading to think of it as a momentum of the price movement of a security.
In the form of ratio, the oscillator is know as Relative Strength Index (RSI). The RSI computes momentum as the ratio of current closing price to close of N period ago. Because the computation methods are different, the figures for ROC and RSI are different, but they can be used the same way. In this article I will use Relative Strength Index (RSI) in the discussion.
Interpretation of Momentum
positive or negative values of momentum: since the ROC is the difference between latest closing price and the price N periods ago, it follows that if the ROC is positive, the latest close is higher than the price N periods ago. If ROC is negative, the latest price is lower. If the latest close is 30, and the close 5 days ago is 25, then the ROC is 5 (30 – 25) if we are talking about 5-day ROC. If the close 5 days ago is 36, the ROC would be -6 (30 – 36).
increasing or decreasing of momentum: if you see on a chart that the ROC is increasing, it means the rate itself is increasing. It does NOT necessarily mean that the price is increasing. It could mean the price has been increasing and is increasing faster now, but it could also mean the price has been decreasing but is decreasing slower now. Conversely, if the ROC is decreasing, it could mean the price has been decreasing and is decreasing faster now, or it could mean the price has been increasing but is increasing slower now.
flat ROC: if the price has been increasing but increasing at a steady pace, the ROC will be zero (or more likely flat than true 0 in real situation). Consider the situation where the price moving is 51, 52, 53, 54, 55, 56, 57, 58, 59, 60, 61, etc. If you do a 5-day ROC, the price different would be 5, 5, 5, 5, 5, etc (56-51, 57-52, 58-53, etc.) , so the ROC is flat. This is the part that is often overlooked or misunderstood. A flat ROC does not mean that the price is flat. It means the rate of change is flat.
zero crossing: if the ROC crosses the zero line from one side to the other, it means the price increase or decrease has change direction. Remembering that ROC above zero means price increasing and ROC below zero means price decreasing, it follows that when ROC cross from above zero to below zero, it means the price increase has stopped and now the price is decreasing. The converse is true for crossing from the other direction. If you look at a chart it might not be that obvious because most chart don’t use a 1-day ROC. In a 7-day ROC, for example, we are looking at the increase or decrease relative to the price 7 days ago.
Figure 1 shows the ROC (shown on the same chart) with increasing prices. Note that all the ROC values are positive because the prices are increasing. Toward the left the ROC is relatively flat because the price is increasing at a steady rate. Toward the right the ROC is moving faster because there is more price change (from steady pace to slowing down); but the ROC is going down although the price is still going up. This is ROC is a measurement of speed. At the very right, the price increase has slowed considerably, thus the ROC is approaching zero.
Fig. 1 5-day ROC with price going up
Figure 2 is the reverse of fig. 1. The price is going down and so the ROC is in the negative range.
Fig. 2 5-day ROC with prices going down
Fig. 3 ROC Crossing Zero
In the next article, we are going to look at some common uses of the momentum oscillator and discuss the strength of those uses.
Comment from electrical transformers
Time May 2, 2011 at 12:02 am
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