Momentum oscillators

Quick definition

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5 min read

Momentum oscillators are technical tools to track a rate of change.

Key details

• A momentum oscillator is a type of leading indicator that measures the amount by which the price of a given security has changed over a given period.
• Momentum oscillators help gauge the strength and momentum of a trend as well as overbought and oversold market conditions. 
• The momentum oscillator is calculated by dividing the current price of a stock with the price of the previous period, which is consequently multiplied by 100.

What is a momentum oscillator?

A momentum oscillator is a type of leading indicator that measures the amount by which the price of a given security has changed over a given period. These sets of indicators help gauge the strength and momentum of a trend as well as overbought and oversold market conditions.

Being an unbound oscillator, the indicator does not have upside and downside limits, as is the case with other oscillators.

The fact that it is a leading indicator means it can detect a possible signal change that is about to occur. The ability to be in sync with price changes means the indicator is always of great help to both day traders and swing traders.

How are momentum oscillators calculated?

The momentum oscillator is calculated by dividing the current price of a stock with the price of the previous period, which is consequently multiplied by 100. For that reason, the indicator oscillates around 100, thus making it possible to identify oversold and overbought situations in a market.

Values above 100 indicate positive momentum, while values below 100 indicate negative momentum.

How does a momentum oscillator work?

Whenever the momentum oscillator reaches an extreme high or low, the same can be interpreted as a continuation of the current price trend, which can be upward or downward. Unlike most oscillators, the momentum oscillator does not have an upper or lower boundary.

Similarly, one must inspect the history of the momentum line to draw upper and lower boundaries.

By drawing upper and lower boundaries, you can identify overbought and oversold situations when it comes to price action. The lack of upper and lower limits means interpreting overbought and oversold conditions is always subjective.

For that reason, the price may continue to move higher or lower even when clearly in overbought or oversold conditions as per the plotted boundary limits.

What is the Chande momentum oscillator?

The Chande Momentum Oscillator is an ideal indicator for detecting overbought and oversold conditions in addition to market momentum. The indicator measures the momentum of both up and down price movements but does not smooth the results like other indicators, thereby triggering more frequent oversold and overbought conditions.

The higher the absolute value in the indicator, the stronger the trend. Likewise, the lower absolute value, on the other hand, signifies market trading sideways or in a range.

Given the indicator oscillates between +100 and -100, a security price would be deemed overbought whenever it is above +50. Likewise, the price would be considered oversold if the oscillator is below -50.

The Chande Momentum Oscillator can be relied upon to provide reliable buy and sell signals. For instance, a buy signal could be in play whenever the oscillator crosses above 0, signalling that prices could be headed higher.

Traders can also use the indicator to detect positive and negative price divergence to ascertain a potential price reversal. A negative divergence would in this case occur whenever the price of a security is trending higher while the Chande Momentum Oscillator is moving downward.

A positive divergence on the other hand would be in focus whenever the price of an underlying security moves lower while the oscillator is rising.

Other types of trading oscillator

While there are different types of oscillators, the two broad categories are centered oscillators that fluctuate above and below a center point and banded oscillators that fluctuate between overbought and oversold territories.

Banded oscillators

Banded oscillators, on the other hand, are ideal when one wishes to identify overbought and oversold territories.

Relative Strength Index (RSI)

The Relative Strength Index is one of the most widely used banded oscillators that technical analysts deploy whenever a market is trading sideways with a lower range of 30 and upper range of 70. While below 30 and above 70 indicate oversold and overbought territories, some analysts consider those to be conservative measures, as they might cause a trader to enter late and miss out on capital gains.

In the chart above, it is clear that whenever the RSI indicator dropped below the 30 level, Microsoft’s price immediately bounced back and started moving higher. The arrows in the chart indicate buying opportunities in this case.

Stochastic oscillator

A stochastic oscillator is another effective banded oscillator for identifying overbought and oversold situations. For stochastic indicators, a reading above 80 is considered overbought, while a reading below 20 is considered oversold.

However, it is important to note that security prices don’t always adhere to overbought and oversold situations. In this case, the price may continue to move lower even in oversold territories as well as up even when entrenched deep in overbought levels, as indicated by a banded oscillator.