Momentum IndicatorWhat It Is: The Momentum indicator is a simple, but effective single-line oscillator that measures the rate of change, or how much a stock’s price has changed, during a given time span. Like any charting tool, it works best in conjunction with other indicator signals. Range: Varies, with a standard mid-point of zero. Default or look-back period: The commonly used default is 12 or 14-day or period. What It Tells You: The Momentum indicator serves as a valuable trend-following indicator. Plot trend lines on the indicator’s value and watch price for main clues as to trend reversals. It also offers “buy” and “sell” signals by way of bullish and bearish divergences. Like most momentum indicators, it gives its best signals when it rises and falls to extreme points on its scales. Figure 3, below, displays a daily chart of the Powershares QQQ (QQQQ), the tracking stock for the Nasdaq 100 index. I’ve also plotted a simple 20-day moving average, and a 14-day Momentum indicator (middle scale).
FIGURE 3. RealTick® graphics used with permission of Townsend Analytics, Ltd. ® 1986 – 2008. Note that the Momentum indicator made a quick bullish divergence as the QQQQ dove lower in mid-January. Note also that the Momentum indicator continued to signal higher lows, but the Qs couldn’t live up to that signal, and sank lower into mid March. This is a great example of how momentum indicators can offer terrific signals at their extremes, but can lose value—especially for short-term traders--as they head toward their mid-scale ranges. It’s also a good reminder that you need to use candlestick signals, moving average support and resistance zones and—most of all—price action, as your main trading indicators. HOT TIP: Keep in mind that chart oscillators and indicators are a fickle bunch. In every situation, price is the ultimate ruler and issues the final word. Still, on a longer-term time frame (green arrows), the bullish divergence ultimately won out, and by the last weeks in March, the Q’s started to March higher. In May and June, the Qs continued their trend-climb upward, but the Momentum indicator was unimpressed—and dove lower in a bearish divergence from price. While the divergence should not have gotten you out of your QQQQ long trade until price weakened in mid-May, you should have certainly recognized the warning signs and monitored open positions closely. In conclusion, please use all momentum indicators as decision-support tools, and consider their signals in conjunction with additional chart indicators. When applied with common sense and discipline, momentum indicators help us refine entries, exits and preserve profits.
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