Application #4 - Chapter 13 - Momentum I: Basic Principles

Momentum, simply defined, is the rate at which occurs e.g. low momentum changes slowly, high momentum changes quickly.

Momentum is forward looking, trends look to the past. This isn't to say that they can tell the future, it simply means that using momentum indicators provide a critical confirmation of changes to trend that enable more accurate confirmation.

Momentum indicators should only be used when the market it is being applied to is demonstrating regular cyclical rhythm i.e. rallies and reactions. They fail to work in a linear uptrend or downtrend.

Examples of momentum indicators include Rate of Change (ROC), Relative Strength Indicator (RSI), Moving-Average Convergence Divergence (MACD), breadth oscillators, and diffusion indexes. In this post I will focus on ROC.

ROC is calculated by (assuming a 10-period time span) dividing the current price by the price 10 periods ago.

As you can see from the above image, ROC (blue line) revolves around an equilibrium. Depending on how ROC is calculated, this is usually 0 or 100. It doesn't matter either way, just as as it's understood that the equilibrium equates to little momentum. Notice also, how volume and price show very little change when ROC is around zero and the huge dip on the plunge downwards.

When ROC is above zero, this shows the price is higher than the base period (example is 10 periods ago, picture is 9). When below zero, it's lower than it was.

Going on the chart above, I would expect to see a move down again, as market averages (those presented at least) are acting as resistance, rate of change has stalled at equilibrium and volume has all but dried out.

To add to the weight of evidence, use multiple time spans. The above shows how when price crossed down through the 30-period moving average (marked at green line), the 18-period ROC had already showed a clear dip down through equilibrium, tying up nicely to the beginning of a sell-off.

Seeing the additional ROC time span shows an increase through equilibrium. Price has already started to increase but I would like to see this reflected in volume before taking any action.

There is much more analysis that can be done using ROC, such as interpreting divergences, smoothing (Coppock indicator) and more. Much more than I have time for in the scope of this post but I would look into more when the circumstances arise.

These posts are application of theory and represent only a portion of any analysis that should be done before committing financially. This is not, in any circumstance, financial/investment advice and should not be interpreted as such.