Momentum is an oscillator that measures the rate at which prices are changing over the Observation Period. It measures whether prices are rising or falling at an increasing or decreasing rate. The Momentum calculation subtracts the current price from the price a set number of periods ago. This positive or negative difference is plotted about a zero line.
The most common uses of Momentum are to:
- Indicate overbought and oversold conditions
An overbought or oversold market is one where the prices have risen or fallen too far and are therefore likely to retrace. If the Momentum line moves to a very high value above the zero line, this is a sign of an overbought market. If the Momentum line moves to a very low value below the zero line this is a sign of an oversold market.
Overbought and oversold signals are most reliable in a non-trending market where prices are making a series of equal highs and lows.
If the market is trending, then signals in the direction of the trend are likely to be more reliable. For example if prices are in an up trend, a safer trade entry may be obtained by waiting for prices to pullback giving an oversold signal and then turn up again.
- Indicate Bullish and Bearish Divergence
Divergence between the Momentum line and the price indicates that an up or down move is weakening.
Bearish Divergence occurs when prices are making higher highs but the Momentum is making lower highs. This is a sign that the up move is weakening.
Bullish Divergence occurs when prices are making lower lows but the Momentum is making higher lows. This is a sign that the down move is weakening.
It is important to note that although Divergences indicate a weakening trend they do not in themselves indicate that the trend has reversed. The confirmation or signal that the trend has reversed must come from price action, for example a trend line break.
Observation period: (default 10)
Normally the Observation Period is set to half the cycle length of the underlying instrument. This means that the Momentum line will peak and bottom along with prices.