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What are momentum indicators?

There are two basic approaches to determining the true or intrinsic value of a stock. Fundamental analysis attempts to determine future share prices by analyzing the company’s financial statements. In contrast, 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. 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 gives 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. Although trendlines, 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. You can use momentum indicators to determine how quickly a particular price is rising or falling. If the momentum indicator is above 100, then current prices are higher than they were 30 days ago. The significant of the index lies in the direction it is moving. If the index is over a 100 and rising every day it shows that the rate of ascent is accelerating. If the index is over a 100 but falling the rat eof ascent is slowing. If the index is under 100 and falling the rate of descent is accelerating. If it is under 100 and rising, the rate of descent is falling. The momentum indicator turns up or down before a turn in the stock market price or market average. As a result the indicator can signal a change in trend. The most popular use of a momentum indicator or rate-of-change index is to look for differences between the index or the security price or market average on which it is based. For example, if the stock prices continues to attain new highs while the momentum indicator is low, this is an early warning signal that the trend is starting to lose momentum. Just because the momentum line diverges from the price line does not mean that the trend has ended or is just about to end. The signal that the trend may be ending is more likely ot be a trend line violation, that is a sharp turn in the moving average of the completion of a chart pattern. If the divergence lasts for a long period of time, which is not unusual, investor should be cautious about adding it to the portfolio during the an up trend or further selling during a down trend. The longer the divergence persists the less likely the trend will remain intact.