I consider momentum to be one of the most effective, yet simple indicators that a trader can use. The proper use of momentum (from this point on referred to as MOM) can yield a host of benefits, not the least of which is the highly precise timing of market entry very close to significant market turning points. This lesson introduces you to my understanding and application of MOM.
MOM is a very simple indicator that is easily calculated. MOM is also known as the rate of change (ROC). Both are essentially the same indicator, but they are derived using different mathematical processes. In order to calculate the five-day MOM of a market, subtract today’s price from the price five days ago. The result is a five-day MOM. If today’s price is 50, and the price was 51 JWPR004-06 JWPR004-Bernstein February 9, 2007, Char Count= 0 52 30 DAYS TO MARKET MASTERY 60 five days ago, then the five-day MOM is −10.
If today’s price is 50, and the price five days ago was 40, then today’s five-day MOM would be +10. MOM is a rate change indicator because it provides you with an idea of trend strength. When MOM is moving down very quickly, it is an indication that prices are changing rapidly on the downside with large price moves. When MOM is rising rapidly, it is an indication that the market is trending strongly higher. MOM can be used as a trading indicator by applying some objective rules
NORMAL AND ABNORMAL RELATIONSHIPS BETWEEN MOM AND PRICE
The normal relationship between price and MOM is for them to exhibit parallel trends as well as similar times for highs and lows. They are “in synch” or coordinated most of the time; but when they are not (i.e., out of phase), we can derive valuable information about market strength and/or weakness. MOM versus price relationships is discussed in this chapter. First, I will illustrate some typical or popular applications of MOM for the purpose of trading.
I will show you some very effective applications of MOM while stressing that these are merely applications and not systems. I believe that they have considerable potential. But they will require additional rules before they can be considered systems. Remember that we will use the setup, trigger, and follow-through method previously discussed. Figures 6.1 and 6.2 show normal MOM relationships.
Abnormal Condition 1: Bearish MOM/Price Relationship
This is a very important condition since it is one in which price and MOM diverge from one another. In other words, they go in opposite directions. If momentum leads to price and if MOM begins to decline while the price is moving up then it’s a reasonable assumption that at some point in the future price will move down.
Unless MOM takes a new direction up, prices are likely to move in the direction of MOM. When the direction of prices and MOM begin to move in opposite directions, the market is telling us that a change in trend is likely. Please remember this rule. I will refer to it again and again.
The Bearish MOM divergence pattern is clear here. Note that as the price was making a high at point A, MOM was NOT making a new high at B. The simple rule here is this: If the price at A is higher than the price at D, while MOM at B is lower than MOM.