Technical Indicators: M (part 3)
Momentum
By measuring the amount that a security's price has changed over a given time span, the Momentum indicator provides an indication of a market's velocity and to some degree, a measure of the extent to which a trend still holds true. It can also be helpful in spotting likely reversal points.
While the mathematics are straightforward (subtract the closing price n days ago from the closing price today), do not underrate its value because of its simplicity.
Use the Momentum indicator as a trend-following oscillator similar to the MACD and buy when the indicator bottoms and turns up. Sell when the indicator peaks and turns down. When the Momentum indicator reaches extremely high or low values (relative to historical values) assume a continuation of the current trend.
A second usage for the Momentum indicator is as a leading indicator. As a market peaks, the Momentum indicator will climb sharply before falling off. At a market bottom, the plot will drop sharply and then climb well ahead of prices.
Momentum %
Momentum % is quite similar to Momentum. The difference lies in that rather than being the difference between today's price and the one of n days prior, Momentum % is a measure of the day as a percentage of the maximum Momentum.
So:
if Pt today's price and Pt-n the price n days ago, Momentum is calculated as:
MOt = Pt - Pt-n
So if you define MOmax the highest absolute value of the momentum, the Momentum % is:
MO%t = MOt / MOmax
The interpretation for Momentum % is the same as that for Momentum, purchase when Momentum % changes from negative positive and sell when it is the reverse.
Money Flow
The Money Flow indicator illustrates the inflows and outflows of cash in regards to a particular stock. While a stock's price simply provides a snapshot in time, Money Flow can show if the market may be discounting some future, significant event.
The equation for Money Flow calculation is simply:
Money Flow = (Typical Price) * (Volume)
Where Typical Price is defined as: (High + Low + Close) / 3
Money Flow values can be used as an independent measurement or as part of the Money Flow Index equation.
Money Flow Index
The Money Flow Index is another momentum indicator illustrating the strength of money flowing into and out of a security. While related to the Relative Strength Index, the Money Flow Index accounts for volume while the RSI only incorporates pricing information.
The calculation of the Money Flow Index requires multiple steps. First, determine the period's Typical Price:
Typical price = (High + Low + Close) / 3
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Calculate Money Flow (not the Money Flow Index) by multiplying the period's Typical Price by the volume:
Money Flow = (Typical Price) * (Volume)
If today's Typical Price is greater than yesterday's Typical Price, it is considered Positive Money Flow. If today's price is less, it is considered Negative Money Flow. Positive Money Flow is the sum of the Positive Money over the specified number of periods. Negative Money Flow is the sum of the Negative Money over the specified number of periods.
Money Ratio = Positive Money Flow / Negative Money Flow
Then finally:
Money Flow Index = 100 - [100/(1+Money Ratio)]
Use the Money Flow Index to look for divergence between the indicator and the price action. If the price trends higher and the MFI trends lower (or vice versa), a reversal may be imminent.
Look for market tops to occur when the MFI > 80. Look for bottoms to when the MFI < 20.
Moving Average Envelope
A Moving Average Envelope chart uses the Moving Averages calculated from the underlying price. The results are shifted up and down by a fixed percentage and imposed over the day's price information.
The underlying concept is that overzealous buyers and sellers will drive prices toward the upper or lower band. Look for the price to penetrate the band followed by a small reversal to predict a large change in direction. This is similar to the interpretation of Bollinger Bands.
MA Envelope, Simple
The Simple Moving Average Envelope consists of moving averages calculated from the underling price, shifted up and down by a fixed percentage.
When prices rise above the upper band or fall below the lower band, a change in direction may occur when the price penetrates the band after a small reversal from the opposite direction.
Remember, because only previous data is used to compute a Moving Average, it will always lags behind the actual prices. As a result, Moving Averages will not predict a change in trend, but rather follow behind the current trend. Use them for trend identification and trend following purposes and not for prediction.
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