This lesson will cover the following
- Explanation and calculation
- How to interpret this indicator
- Trading signals, generated by the indicator
The concept behind this technical indicator is quite simple. Momentum reflects the velocity of price changes and is calculated as the difference between the current bars price and the price a selected number of bars ago. It simply shows the rate at which the price of the trading instrument changes during the specified period of time. The faster the price surges, the more momentum will increase. The faster the price drops, the more momentum will decline. If prices begin changing at a slower rate, momentum will also slow down and return to a more normal level.
Momentum can generate several types of trading signals:
First, crossing over the zero line. In case the Momentum indicator crosses above its zero line, this is considered as a signal to buy.
In case the Momentum indicator crosses below its zero line, this is considered as a signal to sell.
Second, looking for breaches of trend lines. If one is to connect the tops and the bottoms of the Momentum indicator, he/she will be able to place trend lines. Usually momentum starts to shift before the price does, thus, it can be considered as a leading indicator.
In case the indicator breaks above a bearish trend line, this means that a bullish reversal is likely to occur.
In case the indicator breaks below a bullish trend line, this means that a bearish reversal is likely to occur.
Third, taking advantage of overbought and oversold conditions. In this case a trader needs to identify potential overbought and oversold levels, based on historic values of the indicator. After he/she has identified the two extreme levels, the next step is to make sure that at least two-thirds of previous Momentum readings occur between these extremes.
A buy signal is generated, when the indicator falls below the oversold level and then moves back above it. A sell signal is generated, when the indicator climbs above the overbought level and then moves back below it.