Introduction to Momentum
What is momentum, and how does it apply to the stock market?
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In physics, as in my Select 'n Shoot tennis games, momentum is understood to be the product of mass and velocity, say of a ball. To get a sense of momentum as applied in the stock market, note how Burton Malkiel uses it:
Supposedly, stocks that have been rising will continue to do so, and those that begin falling will go on sinking.
Martin L Pring expresses a similar sentiment, saying that once a trend is set in motion, it will perpetuate itself.
The meaning, here, is that the market tends to persist in its movement. This is more like inertia than momentum, but it's close enough for now, because inertia is a property of mass (weight), which is a component of momentum. Newton's principle of inertia is that a body remains at rest or constant velocity unless acted upon by an external force. It takes force to change the velocity -- i.e., to accelerate or decelerate a body from any speed.
Malkiel doesn't think the market exhibits momentum, even in the sense of inertia. He says stock prices can't be used reliably to foretell future movements, that in fact the stock market has no memory. The market behaves like a random walk -- but that's another story.
On the positive side, Norman G Fosback believes there is price persistency, that there is evidence to show rising prices tend to follow rising prices, and falling prices tend to follow falling prices.
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In physics -- in theoretical mechanics -- momentum applies to physical objects and involves two classical concepts, namely velocity and mass. It's defined as their product:
momentum = velocity times mass.
Velocity is the time rate of change of position and tells you how fast something is moving.
The concept, mass, is more abstract, because we never experience it directly. But we come close with the feeling of weight, which requires a gravity field. So, mass tells you how much something is going to weigh when in a gravity environment. You can feel when something is heavy or not, right? The greater the mass of an object, the heavier the object is. And the less mass it has, the lighter it is -- for any given gravity field.
So momentum measures the ability of an object to continue in its path. Objects with a lot of momentum are hard to stop. A train loaded with munitions, for instance, has a lot of weight, and I'm sure you wouldn't try to stop it. On the other hand, a speeding bullet has a lot of velocity. And even though it doesn't have much weight, I'm sure you wouldn't try to stop that, either. Both a loaded train and a speeding bullet have high continuation value -- high momentum. You can imagine, then, how difficult it would be to stop a train traveling at the speed of a bullet!
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Relative to stocks, bonds, commodities, currencies, etc., what, if anything, might correspond with velocity? And what might be like mass?
Mass Equivalent?
The only physical mass that stocks have is the mass of their stock certificates. So it would have to be something that only seems like mass, like the number of shares in a trade -- the more shares, the higher the "mass"? Maybe. If so, a thousand-share trade, say, would be ten times "heavier" that a hundred-share trade. At least as far as the wallet is concerned.
Velocity Equivalent?
What, then, might be the velocity? To have any meaning, it would have to be something with a sense of movement. The only option appears to be the price. But price doesn't have the sense of motion. It's more like position -- it just sits there.
Rather, it would have to be a change in price -- like a change in location. It could be the difference between the last recorded price and the current price (the strike price). That difference would provide the sense of movement. At least it would be grammatically correct to say the price moved from A to B, even though there wouldn't be intermediate values. (This sounds like quantum mechanics!) The velocity would then be expressed as the change in price per trade.
Momentum would then be the product of the number of shares and the change in price per trade. Say the price of a stock is $20 and a hundred-share trade jumped the price two points, to $22. The momentum would then be 200 units.
A more normal approach would be to associate the price change with some interval of time, like a day, week, month, etc., rather than over a given trade. In this approach, more formally, "velocity" would be the numerical change in price per unit of time.
What About Price?
In the above view, the actual price of the stock isn't a consideration in the formula. If the price had been $40, for instance, a price change of 2 points for 100 shares would have yielded the same value for momentum. But should it? In fact, if we're really talking about momentum, shouldn't the value be different in the two cases?
One possibility is to consider not just the number of shares for the mass, but rather the number of shares involved in the trade times the price. In this event, the mass of 100 shares of the $40 stock would be 40,000 units, and the mass of 100 shares of the $20 stock would be 20,000 units. So the respective momentums would be 80,000 and 40,000. The momentum of the "heavier" stock would be twice as much as that for the "lighter" one. Seems reasonable. But this interpretation isn't used, either!
What about percentage price change? How do you reconcile the lesser momentum with a greater proportionate move in price? After all, a two point move in a $20 stock is better than a two point move in a $40 stock -- twice as good, in fact. If momentum is to help select stocks, shouldn't it reflect this significant difference? Indeed, shouldn't momentum favor the bigger percentage move? Or is this too much to expect from momentum? In fact, percentage change is on target, but the other stuff is just extra baggage!
Bare Minimum Interpretation
A bare minimum approach to momentum would be to ignore both the price of the stock and the number of shares and let the mass take only a unit value, and use the price change per unit time as velocity. In this approach, momentum would correspond numerically to velocity, even though the formal statement would be in units of mass times velocity. In fact, this view does seem to be prevalent, although there's generally no mention of mass in any sense. See what Martin L Pring has to say, here.
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In his book, Martin Pring on Market Momentum, Pring develops a market theory based on market momentum. His view is that there are two ways to understand momentum in the market, namely as:
The internal measures of momentum are referred to as oscillators, and momentum measures of price averages are described as rates of change.
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It's to be understood that a rate of change is a measure of price change over a specified period of time, somewhat as I discuss it here, where momentum is understood as velocity.
So, if a ten-week interval is used, presumably you take the difference between today's price and the price of ten weeks ago and divide by ten. For example, if the current price is 100 and the price ten weeks ago was 105, the price would have fallen by five points, so the difference would be negative five, and the rate of change for the period would be -5/10 = -.5.
But this doesn't give us Pring's results!
Instead, Pring divides 100 by 105 to get 95.2 for his measure of price change. Why does he do this, and how does he arrive at this result?
To get the answers, let's take another step and consider using the percentage change in price over the period. For the given example, to get the percentage change we would have to divide -5 by 105, getting about -4.8 %. Now, happily, we're close to Pring's result, because 4.8 is the difference between 100 and 95.2. But why this difference?
To follow up with the comparison, say the current price is 105. In that case, the percentage change would be 0%. And if the current price is 110, the percentage change would be +4.8%. Pring's values for the three conditions are, respectively, 95.2, 100, and 105.2.
Comparing the corresponding values of Pring's results with mine, the difference in each pair is 100. So, instead of using zero as the break point between a losing and a winning percentage increase, Pring uses 100. In other words, he shifts values to the positive side by 100. By shifting to positive values, he avoids using negative numbers and gets momentum in one step.
The bottom line is that Pring uses percentage change of prices for momentum and uses a neat trick in arithmetic to measure the values.
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The other meaning of momentum for Pring -- referring to the vitality of the market -- is the number of stocks participating in an advance and the volume of shares being traded. Market breadth itself is measured by an advance/decline line, constructed by cumulating the difference between the number of stocks advancing over those declining within a given time period, like a day or a week.
To get a measure of the momentum of market breadth, Pring divides the total number of shares advancing in a given period by the total number of declines. He then constructs a momentum oscillator by forming a moving average of the breadth momentum.
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New Highs/Lows Momentum
In an approach developed by Welles Wilder, momentum is understood to be the ratio of the average of new highs for a defined period of time to the average of new lows for that time period.
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