The concept of momentum is the most basic application of oscilla­tor analysis. Momentum measures the velocity of price changes as opposed to the actual price levels themselves. Market momentum is measured by continually taking price differences for a fixed time interval. To construct a 10 day momentum line, simply sub­tract the closing price 10 days ago from the last closing price. This positive or negative value is then plotted around a zero line. The formula for momentum is:
M = V - Vx
where V is the latest closing price and Vx is the closing price x days ago.If the latest closing price is greater than that of 10 days ago (in other words, prices have moved higher), then a positive value would be plotted above the zero line. If the latest close is below the close 10 days earlier (prices have declined), then a negative value is plotted below the zero line.
While the 10 day momentum is a commonly used time period for reasons discussed later, any time period can be employed. (See Figure 10.1a.) A shorter time period (such as 5 days) produces a more sensitive line with more pronounced oscil­lations. A longer number of days (such as 40 days) results in a much smoother line in which the oscillator swings are less volatile.
Momentum Measures Rates of Ascent or Descent
Let's talk a bit more about just what this momentum indicator is measuring. By plotting price differences for a set period of time, the chartist is studying rates of ascent or descent. If prices are ris­ing and the momentum line is above the zero line and rising, this means the uptrend is accelerating. If the up-slanting momentum line begins to flatten out, this means that the new gains being achieved by the latest closes are the same as the gains 10 days ear­lier. While prices may still be advancing, the rate of ascent (or the velocity) has leveled off. When the momentum line begins to drop toward the zero line, the uptrend in prices is still in force, but at a decelerating rate. The uptrend is losing momentum.
When the momentum line moves below the zero line, the latest 10 day close is now under the close of 10 days ago and a near term downtrend is in effect. (And, incidentally, the 10 day moving average also has begun to decline.) As momentum con­tinues to drop farther below the zero line, the downtrend gains momentum. Only when the line begins to advance again does the analyst know that the downtrend is decelerating.
It's important to remember that momentum measures the differences between prices at two time intervals. In order for the line to advance, the price gains for the last day's close must be greater than the gains of 10 days ago. If prices advance by only the same amount as 10 days ago, the momentum line will be flat. If the last price gain is less than that of 10 days ago, the momen­tum line begins to decline even though prices are still rising. This is how the momentum line measures the acceleration or deceler­ation in the current advance or decline in the price trend.
The Momentum Line Leads the Price Action
Because of the way it is constructed, the momentum line is always a step ahead of the price movement. It leads the advance or decline in prices, then levels off while the current price trend is still in effect. It then begins to move in the opposite direction as prices begin to level off.
The Crossing of the Zero Line as a Trading SignalThe momentum chart has a zero line. Many technicians use the crossing of the zero line to generate buy and sell signals. A crossing above the zero line would be a buy signal, and a cross­ing below the zero line, a sell signal. It should be stressed here again, however, that basic trend analysis is still the overriding consideration. Oscillator analysis should not be used as an excuse to trade against the prevailing market trend. Buy posi­tions should only be taken on crossings above the zero line if the market trend is up. Short positions should be taken on crossings below the zero line only if the price trend is down.The Need for an Upper and Lower Boundary
One problem with the momentum line, as it is described here, is the absence of a fixed upper and lower boundary. It was stated ear­lier that one of the major values of oscillator analysis is being able to determine when markets are in extreme areas. But, how high is too high and how low is too low on the momentum line? The simplest way to solve this problem is by visual inspection. Check the back history of the momentum line on the chart and draw horizontal lines along its upper and lower boundaries. These lines will have to be adjusted periodically, especially after important trend changes have occurred. But it is the simplest and probably the most effective way of identifying the outer extremities.

The oscillator is only a secondary indicator in the sense that it must be subordinated to basic trend analysis. As we go through the various types of oscillators used by technicians, the impor­tance of trading in the direction of the overriding market trend will be constantly stressed. The reader should also be aware that there are times when oscillators are more useful than at others. For example, near the beginning of important moves, oscillator analysis isn't that helpful and can even be misleading. Toward the end of market moves, however, oscillators become extremely valuable. We'll address these points as we go along. Finally, no study of market extremes would be complete without a discussion of Contrary Opinion. We'll talk about the role of the contrarian philosophy and how it can be incorporated into market analysis and trading.
Interpretation of Oscillators
While there are many different ways to construct momentum oscillators, the actual interpretation differs very little from one technique to another. Most oscillators look very much alike. They are plotted along the bottom of the price chart and resemble a flat horizontal band. The oscillator band is basically flat while prices
may be trading up, down, or sideways. However, the peaks and troughs in the oscillator coincide with the peaks and troughs on the price chart. Some oscillators have a midpoint value that divides the horizontal range into two halves, an upper and a lower. Depending on the formula used, this midpoint line is usu­ally a zero line. Some oscillators also have upper and lower bound­aries ranging from 0 to 100.
General Rules for Interpretation
As a general rule, when the oscillator reaches an extreme value in either the upper or lower end of the band, this suggests that the current price move may have gone too far too fast and is due for a correction or consolidation of some type. As another general rule, the trader should be buying when the oscillator line is in the lower end of the band and selling in the upper end. The crossing of the midpoint line is often used to generate buy and sell signals. We'll see how these general rules are applied as we deal with the various types of oscillators.
The Three Most Important Uses for the Oscillator
There are three situations when the oscillator is most useful. You'll see that these three situations are common to most types of oscillators that are used.
1. The oscillator is most useful when its value reaches an extreme reading near the upper or lower end of its bound­aries. The market is said to be overbought when it is near the upper extreme and oversold when it is near the lower extreme. This warns that the price trend is overextended and vulnerable.
2. A divergence between the oscillator and the price action when the oscillator is in an extreme position is usually an important warning.
3. The crossing of the zero (or midpoint) line can give impor‑tant trading signals in the direction of the price trend.