What is Momentum?
Momentum (MOM) is a straightforward indicator that calculates the rate at which the price of a security is changing. The formula for momentum is:
- P is the current price.
- Pn is the price n periods ago.
How does Momentum work in a trading scenario?
In trading, Momentum is used to identify the strength or weakness of a trend. Positive momentum values indicate the price is increasing over time, while negative values indicate the price is decreasing over time. Here's how it can be interpreted:
- Crossing Above Zero: When MOM crosses above zero, it may be a bullish signal.
- Crossing Below Zero: When MOM crosses below zero, it may be a bearish signal.
- Divergence: If the price is making new highs/lows but momentum is not, it may signal a reversal.
Suppose a stock's price was $50 10 days ago and today it's $55. The momentum would be: MOM=55−50=5.
This positive momentum value suggests that the stock is on an upward trend.
Limitation of Momentum
One limitation of the momentum indicator is that it doesn’t account for the fundamental factors affecting a security’s price. Additionally, in volatile markets, the momentum indicator can produce false signals which may mislead traders into making unprofitable trades.