Momentum and rate of change oscillators have similar uses for finding short-term changes in direction. They are essentially the same tool, except that rate of change oscillators give readings in percentage form, whereas momentum oscillators give readings in point form. Moving average oscillators are best for trading with a trend.

How it works?

A momentum oscillator measures the acceleration or deceleration of price rather than the actual price level. For example, a five-period momentum oscillator will calculate the difference between the current period's closing price and one five periods ago (whether the period is a day, a minute, or a week). At the end of each time period, the resulting figure is plotted on a graph, and the resulting graph will tend to oscillate around zero. With a simple momentum oscillator like this, there are no upper or lower boundaries as there are with rate of change oscillators. In the example just given, a time period of five would yield a more sensitive oscillator than the more standard 10-period graph. Conversely, a time period of 20 would give a less sensitive graph.

The basic idea behind a momentum oscillator is that for a security to reverse direction, it must decelerate in its current direction and reach zero velocity before picking up momentum in a new direction. Think of this in the same way as throwing a ball up in the air. The vertical velocity has to slow to zero before the ball can change vertical direction and start heading down again. Of course, unless you have a ball with its own way of generating thrust, the ball must head down after reaching zero vertical velocity. This is not necessarily true of a security. It may reach zero on the oscillator, but it can get a new injection of thrust from a news story or some other market action. Bearing that in mind, an oscillator is not as sure a bet as gravity working on a ball, but it can be a useful secondary indicator on occasion.

Example

An example of a momentum oscillator is shown in the figure. This one uses the equation M = P – Px, where M is the value plotted on the oscillator, P is the current period closing price, and Px is the closing price x number of periods ago.

In this case, we can see that during the opening 20 minutes, this security gained momentum. At around 9:55 a.m., the momentum leveled off, and close to 10:00 a.m., the momentum started to head down. It is imperative to remember that the momentum line is measuring the difference between price at two time intervals. In order for this oscillator to gain in value, the difference in closing price between the two periods being studied must be getting greater. Essentially, if this type of oscillator is flat, it means that a stable trend is in effect and the price increases (or decreases) are constant. Any reading above the zero line means that prices are increasing. Any reading below the oscillator zero line means that prices are falling.

Given the significance of the zero line for this type of oscillator, a crossing of this line is often used to generate trading signals. Following these crossings of the zero line is, however, a bad thing to do without further knowledge.

If a security is trending up, only crossings from negative to positive territory should be used as buying signals, and you would ignore the sell signals from a cross from positive to negative territory. This is a good tactic for when you are looking to find appropriate entry points for getting in on a trend, because it will make you wait until the security has pulled back to an area of support and has started to appreciate in value again before initiating a position. Note, however, that you first have to have identified the trend using basic charting principles in order for this to be of any use. The reverse is true, of course, for a security in a downtrend. In that case, crosses from above to below the zero line are used to confirm entry points.

In the figure example, the broad interpretation of the momentum graph is as follows. During the search for overreaction, followed by reversal, the momentum is positive and gaining, so long positions are appropriate. Any longs should be liquidated by 9:55 a.m., because the momentum has leveled off. By 10:00 a.m. the trader should be looking for shorts, since the momentum is negative. At around 10:25 a.m. the momentum is starting to reverse up, so shorts should be liquidated. Toward the end of the graph, at noon, the momentum is stuck around zero, and you would move on to look for another security that is either trending or has momentum.