Technical analysts can turn to hundreds, if not thousands, of indicators. Many are designed to measure momentum. Analysts have created these indicators in search of an edge, a tiny advantage that gives them a chance for profits by getting ahead of other traders.
Momentum is considered to be the velocity of price changes, in general terms. Technical analysts aren’t trying to say a price is moving at a certain, steady rate, like the velocity of a car. They are trying to determine when the price is moving, or delivering gains in a trending manner, or when a reversal is due.
The latter is the most common use of momentum indicators. They are, in mathematical terms, based on the idea of mean reversion.
Prices As a Rubber Band
Traders using momentum indicators often think of prices as behaving as if they were a rubber band in the short term. This analogy shows that when prices are pulled too far, they should quickly snap back reversing the rapid move that created the stretched price levels.
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The chart below shows a simple application of this idea. Red arrows show levels where prices have moved too far above the moving average and green arrows show where prices are stretched below the moving average. In both cases, snap backs are expected and occur to varying degrees.
This chart includes daily closing prices as the black line and a 5 day moving average (MA). The MA is the central point and we expect a snap back when prices move too far above or below the MA.
Defining the Idea of Stretched
As the chart above shows, prices do at times behave like a rubber band. But, for traders the question is how they can benefit from this tendency in real time. Traders have devoted a great deal of effort to this question and come up with a variety of momentum indicators.
Among the popular momentum indicators are tools such as RSI, stochastics and MACD. Each of these attempts to define momentum with calculations that are intended to show whether recent action is bullish or bearish.
Each of these indicators, and others, have detailed rules for finding trade signals. For stochastics for example, the trader may be looking to sell when the indicator rises above 80. This is a high reading for the indicator which is bounded by 100 on the up side and 0 at the low end.
Each of these indicators use a series of calculations to smooth the price action. That series of calculations is one of the drawbacks of these indicators. By smoothing the data, the signal will come after the price action reverses.
In other words, although these indicators are intended to anticipate trend reversals, their calculation means that they will rarely be able to do that.
A less popular indicator, a simple rate of change (ROC) calculation, will be more responsive to price action and is therefore more likely to actually spot times when the rubber band is, in effect, stretched too far. An example of this indicator is shown in the next chart.
ROC As a Trading Tool
The formula for ROC is simple and it does not smooth the data. To find ROC, the most recent close is divided by the close of several days ago. In the chart above, a 5 day ROC is shown. Any time frame could be used. A shorter time frame will be more volatile and a longer one will provide fewer trade signals.
Unlike stochastics or RSI, the ROC will not be bounded. It can take on any value. This makes it similar to MACD and that is why the MACD style histogram is used in the chart above.
To use ROC as an overbought or oversold indicator, traders can watch the indicator for peaks. When it is above zero (red in the chart above) and rising, the trend is up. When ROC falls, for either one or two days, traders have a sell signal.
When ROC is below zero, traders will have a buy signal when the indicator rises compared to its level of one or two days earlier.
ROC has another unique property. It can be used to show when a rally has entered bubble territory. The next charts shows the Nasdaq 100 index in the late 1990s, as the internet bubble unfolded. A 52 week ROC is shown and the horizontal line is drawn at 100%.
Notice that prices pulled back after ROC topped 100%. This is an unsustainable pace of advance. ROC shows when prices just cannot continue at their current pace. This was an extreme, once in a lifetime bubble.
Normally, when the 52 week ROC tops 40%, the price advance is unsustainable. At that pace, the price will more than double every two years. Few stocks will ever have that sort of growth in a sustainable manner.
The same is true for commodities. When prices are advancing at more than 40% a year, a decline is likely. The gain will attract more suppliers which will reduce prices and the high prices will reduce demand, also deterring further gains.
Few, if any other indicators, are useful for spotting bubbles. No indicator will be fool proof as the chart of the Nasdaq 100 shows. But, the message from ROC was clear that the price advance was not sustainable.
Investors who missed the message suffered severe losses. The index would fall 80% from its high. This means ROC was early, but useful.
Traders may find that ROC, the simplest indicator, could be among the most useful they will find.
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