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Momentum is the speed or velocity of price changes in a stock, security, or tradable instrument. It shows the rate of change in price movement over a period, helping investors determine the strength of a trend. Stocks that tend to move with the strength of momentum are called momentum stocks.
Momentum is used by investors to trade stocks in an uptrend by going long (or buying shares) and going short (or selling shares) in a downtrend. In other words, a stock can exhibit bullish momentum, meaning the price is rising, or bearish momentum, where the price is steadily falling.
Since momentum can be quite powerful and indicate a strong trend, investors need to recognize when they’re investing with or against the momentum of a stock or the overall market.
Key Takeaways
- Momentum is the speed or velocity of price changes in a stock, security, or tradable instrument.
- Momentum shows the rate of change in price movement over a period of time to help investors determine the strength of a trend.
- Investors use momentum to trade stocks, whereby a stock can exhibit bullish momentum (the price is rising) or bearish momentum (the price is falling).
Calculating Momentum
There are many charting software programs and investing websites that can measure momentum for a stock so that investors don’t have to calculate it anymore. However, it’s important to understand what goes into those calculations to better understand what variables are used in determining a stock’s momentum or trend.
In his book, “Technical Analysis of the Financial Markets,” author John J. Murphy explains:
Market momentum is measured by continually taking price differences for a fixed time interval. To construct a 10-day momentum line, simply subtract the closing price 10 days ago from the last closing price. This positive or negative value is then plotted around a zero line.
The formula for momentum is:
Momentum=V−Vxwhere:V=Latest priceVx=Closing pricex=Number of days ago- In the summer of 2016 (the left-hand side of the chart), we can see that momentum was choppy (orange box) while the S&P 500 traded sideways.
- In September 2017, we can see that both momentum and the S&P broke out (orange arrows), rallying, whereby the S&P eventually touched 2,875.
- In January and December 2018, momentum began collapsing and fell below zero (pink arrows), taking the S&P with it.
- The market rallied in early 2019, but momentum turned bullish again, breaking above zero, while the S&P raced higher to about 3030.
Momentum as a Strength Indicator
Momentum measures the rate of the rise or fall in stock prices over a period. It can be thought of as the acceleration or deceleration of a stock’s price movement. For example, if during a 10-day trading period, XYZ’s stock price rose from $1.00 to $1.02 on the first two days, to $1.04 on the next two, to $1.06 on the next two, and so on, until it reached $1.22 on the tenth day. Using the closing price from 10 days ago and the latest closing price, the result is $0.20 = $1.22 – $1.02.
When plotted on a chart of previous momentum results, it would be above the zero line and could be viewed as having momentum if all other results of a 10-day analysis trended upward also.
Thus, momentum is a useful indicator of an asset’s strength or weakness in its price.
Measuring Momentum
Technicians typically use a 10-day time frame when measuring momentum. In the chart below, momentum is plotted for the price movements of the S&P 500 Index, which is an excellent indicator of the trend for the overall stock market. Please note that, for illustrative purposes, the chart below displays only the momentum (the calculated value) for the S&P, excluding index prices.
If the most recent closing price of the index is more than the closing price 10 trading days ago, the positive number (from the equation) is plotted above the zero line. Conversely, if the latest closing price is lower than the closing price 10 days ago, the negative measurement is plotted below the zero line.
The zero line is essentially an area where the index or stock is likely trading sideways or has no trend. Once a stock’s momentum has increased—whether it’s bullish or bearish—the momentum line (blue line) moves farther away from the zero line (orange line).
Without looking at the price of the S&P and only using momentum, we can see that it’s likely the S&P index rallied in tandem with the spikes above zero on the momentum indicator below. Conversely, it’s likely the index fell on the large downward moves below zero.
If we overlay the price of the S&P 500, along with momentum, we can see that the index corresponds or correlates fairly well with moves in momentum.
From the chart above, we can see that if momentum is above zero, but not trending higher, it can lead to the S&P’s price falling eventually—as in the case of May-through-September 2019 (in between the two pink arrows). Many investors and traders watch the movements in momentum and the S&P, because if the two are not moving in sync, something is amiss. In other words, either the S&P or momentum needs to adjust.
Special Considerations
When the momentum indicator slides below the zero line and then reverses in an upward direction, it doesn’t necessarily mean that the downtrend is over. It merely means that the downtrend is slowing down. The same is true for the plotted momentum above the zero line. It may take a few moves above or below the zero line before a trend is established.
It’s important to note that many factors drive momentum. Economic growth in the economy, earnings reports, and the Federal Reserve’s monetary policy all impact companies and whether their stock prices rise or fall.
In other words, momentum isn’t a predictor of price movement, but instead, reflective of the overall mood and fundamentals of the market. Also, geopolitical and geofinancial risks can drive momentum and money into or away from stocks. Although it’s helpful for investors to understand the market’s momentum, it’s also important to know what factors are driving momentum and ultimately price movements.
What’s the Best Momentum Strength Indicator?
The most often used momentum strength indicator is the relative strength indicator, but there are many others. One isn’t necessarily better than the other, but they can all be used to gauge price momentum and strength.
What Does a High Momentum Stock Mean?
A high momentum stock is one whose change in price is consistently above zero.
What Is a Good Momentum Score?
Momentum scores are generally determined by analysts, so good scores will be based on their scoring techniques. If you’re using closing prices, calculating momentum, and placing the results on a chart, price changes that remain above the zero line are good scores.
The Bottom Line
Momentum is a useful indicator for measuring strength in price movements and subsequent trend development. Like many price-oriented indicators, it is useful to review its measures in combination with other technical or fundamental data as a means of looking for divergences.
