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What is a momentum indicator? How is it used?

Technical analysis focuses on the price movements themselves rather than the fundamental approach of analyzing the factors that cause price movements. Technicians believe that all known influences are fully reflected in market prices. By studying market action, the technicians rely on the market to indicate the direction and extent of its next price move. Market action focuses on two sources of information – prices and volume.

The key premise on which technical analysis is based is that prices move in trends and trends tend to persist for long periods of time – this is why technical analysis is known as momentum investing. The primary objective of technical analysis is to identify trends, preferably in the early stages, and carry positions in that direction until the trend reverses itself. The methods used to identify trends and trend turning points can be divided into three board categories: chart analysis, statistical analysis and analysis of sentiment indicators. They are usually used together. Chart Analysis The most common type of chart is one that shows the hourly, daily, weekly, monthly or yearly high, low or close of a particular stock or market average. This information usually includes the volume of trading. The Dow Theory, used in conjunction with chart analysis, uses three techniques for determining the market’s primary trend: price movement, confirmation of moving averages and volume. According to the Dow Theory, the market average is considered to indicate a bull market when the market has experienced a broad upward price movement for at least a year and when each successive peak reaches a higher level than the one before and each trough stops at a higher level than the one before. A bear market is characterized by a market average that has been moving downwards in price for at least a year in which each successive trough reaches a lower level than the one before and each secondary reaction (price rise) stops at a lower level than the one before. A primary trend continues until if gives a definite signal that it is going to change direction, or reverse. For a primary up trend (bull market) to be considered in reversal, prices must have at least one lower high and one lower low. For a downtrend (bear market) to be considered in reversal prices must have one higher high and one higher low. Confirmation of Moving Averages An important tenet of the Dow Theory is that the movement of the Dow Jones Industrial Average and the Dow Jones Transportation Average should confirm one another. The rationale behind this principle is that if the market is anticipating healthier business conditions investors should be bidding up the prices of companies that produce goods as well as the companies that transport those goods. This means that a change in one average is not enough to signal a change in the overall market trend. Volume Although conclusive signals about market trend are found only in price movements, volume is a confirming indicator. In a bull market, volumes typically expand as prices rise and fall as price declines. If prices set a new rally high but volumes are sluggish, it may indicate a weakening of the trend. Volume in bear markets has proven to be a less reliable confirmation of a trend than in bull markets. Rising markets need volume to confirm a primary trend whereas bear markets can fall on light volume. Statistical Analysis Statistical analysis includes two tools -- moving averages and momentum indicators. Moving averages are lagging indicators that are designed to indicate buying or selling opportunities once a trend is firmly established. Moving averages smooth out price movements to identify the underlying trend of the market. Before using a moving average, the type of moving average and the number of days to be averaged must be chosen. A ten-day moving average is simply the total of the last ten trading closes divided by 10. On the eleventh day, the new closing price is added and the close from eleven days before is subtracted. A simple moving average give equal weight to each day during the period. Weighted and exponential moving averages give more weight to recent prices. The most popular long term moving average for market averages is the 40 week (or 200 day) moving average. This moving average has a good track record in identifying primary trends. Momentum Indicators Although trend lines, the Dow Theory, chart patterns and moving averages are useful indicators, they identify changes after they occur. Momentum indicators are used to detect a warning signal before a trend takes place. Momentum indicators measure the rate of change of a security price or market average. The simplest method of calculating momentum is to take the current price and divide it by the price that was posted several days, weeks or months ago. To measure the 30-day rate of change the current price is divided by the price 30 days ago and the result multiplied by 100. If the price was $50 and the and the price 30 days ago was $45, the 30 day rate of change or momentum index is 111 (50/45 * 100). If, on the following day, the price is $52 and the price 30 days before was $46, the momentum index is 113. These indexes show that the price momentum is upwards. Sentiment Indicators Sentiment indicators focus on investor expectations. Contrarian investors use these indicators to assess the price expectations of the majority of investors. If the majority feels strongly that the prices will rise, contrarian investors behave as if they will fall. The rationale is that if most investors are of the view that prices will rise there are not enough investors to push prices much higher. A variety of measures are used to measure overall market sentiment including: Fundamental Analysis Fundamental analysis predicts a company’s future share price by searching for clues about a company’s future performance by assessing growth, dividend payout, interest rates and risk. Fundamental and involves a detailed examination of the company’s financial statements and the calculation of various ratios.