Market Momentum: What It Means and How It Works

What Is Market Momentum?

Momentum is the rate of acceleration of a security's price—that is, the speed at which the price is changing. Market momentum refers to the aggregate rate of acceleration for the broader market as a whole.

Market momentum can be used as a measure of overall market sentiment that can support buying and selling with and against market trends. It is one of several indicators that can help an investor to follow price trends.

Market Momentum Formula

Generally, market momentum can be defined from the following equation:

$\begin{aligned} &M = V - V_x\\ &\textbf{where:}\\ &V = \text{The latest price}\\ &V_x = \text{The closing price }x\text{ number of days ago}\\ \end{aligned}$​M=V−Vx​where:V=The latest priceVx​=The closing price x number of days ago​

This equation can lead to the drawing of a trendline with varying periods used in the calculation.

Understanding Market Momentum

Positive momentum can indicate a potential bullish trend while negative momentum can indicate a bearish trend. Broadly, momentum can be measured across both asset classes and individual securities, with market momentum, in particular, referring to the overall market.

Momentum trading is a strategy that seeks to capitalize on the momentum to enter a trend as it is picking up steam. In equities, broad market increases in corporate profits can help to create positive price momentum. In fixed-income securities, falling interest rates can be a catalyst for price momentum.

Investors can use momentum as a trading technique that seeks to profit from the herding behavior of market psychology. Once a momentum trader sees acceleration in a stock's price, earnings, or revenues, the trader will often take a long or short position in the stock in the hope that its momentum will continue in either an upward or downward direction. This strategy relies on short-term movements in a stock's price rather than fundamental value.

Technicians typically use a 10-day time frame when measuring market momentum. In the chart below, momentum is plotted for the price movements of the S&P 500 Index, which is an excellent indicator of the trend for the overall stock market. (For illustrative purposes, the chart below is only the momentum for the S&P and excludes the prices from the index.)

Without looking at the price of the S&P and only using momentum, we can see that it's likely the S&P index rallied in tandem with the spikes above zero on the momentum indicator below. Conversely, the index likely fell on the large downward moves below zero.

Market Momentum Indicators

Investors and technical traders can follow several indicators to gauge market momentum.

Momentum Indexes

Market momentum indexes provide momentum indicators for various market sectors. MSCI and FTSE Russell are two companies that have introduced momentum indexes.

The MSCI momentum indexes are part of the company’s factor index series. Momentum indexes include the MSCI USA Momentum Index and the MSCI World Index. The indexes base their methodology on a momentum score.

FTSE Russell also manages the Russell 1000 Momentum Focused Factor Index which was introduced in 2015. With the launch of this index, State Street Global Advisors also launched the SPDR Russell 1000 Momentum Focus ETF (ONEO), which is a passive ETF that tracks the Index.

Momentum Indicators

In technical analysis, momentum can be a very profitable indicator to follow for trading signals on individual securities. Below are some of the popular momentum indicators technical analysts follow.

Moving average (MA) is among the simplest ways to follow momentum. The moving average is an average of a security's price over a specified period of time. Higher moving average trendlines signal positive momentum while descending moving average trendlines signal negative momentum. To add to that, moving average convergence divergence (MACD) is calculated using an exponential moving average.

Volume weighted average price (VWAP) is another widely-used momentum indicator. The VWAP allows a trader to follow how a price is trending in relation to its volume. Significant increases in the VWAP can be a strong bullish signal while significant decreases can be a strong bearish signal. It is calculated as:

$\begin{aligned} &VWAP = \dfrac{TS \times P}{TS} \\ &\textbf{where:}\\ &TS = \text{Total Shares Bought}\\ &P = \text{Share Price}\\ \end{aligned}$​VWAP=TSTS×P​where:TS=Total Shares BoughtP=Share Price​

Positive and Negative Volume Indexes (PVI and NVI) are another tool that has been developed to provide an indicator for how volume is affecting price. They are calculated from the following:

$\begin{aligned} &PVI = Previous~PVI + \\ &(\dfrac{TC - YC}{YC} \times Previous~PVI)\\ &\textbf{where:}\\ &TC = \text{Today's Closing Price}\\ &YC = \text{Yesterday's Closing Price}\\ \end{aligned}$​PVI=Previous PVI+(YCTC−YC​×Previous PVI)where:TC=Today’s Closing PriceYC=Yesterday’s Closing Price​

$\begin{aligned} &NVI = Previous~NVI + \\ &(\dfrac{TC-YC}{YC} \times Previous~NVI)\\ \end{aligned}$​NVI=Previous NVI+(YCTC−YC​×Previous NVI)​

Relative Strength Index (RSI) is intended to provide a momentum indicator through the evaluation of how a price is changing in relation to the speed and amount of change occurring over a specified timeframe. It is calculated using the following formula:

$\begin{aligned} &RSI = 100 - \dfrac{100} {(1+RS)} \\ &\textbf{where:}\\ &RS = \\ &\dfrac{\text{\small Average Up Period Gains throughout a Specified Time Frame}}{\text{\small Average Loss from Down Periods over a Specified Time Frame}}\\ \end{aligned}$​RSI=100−(1+RS)100​where:RS=Average Loss from Down Periods over a Specified Time FrameAverage Up Period Gains throughout a Specified Time Frame​​

The Bottom Line

Market momentum is the speed at which a security's price is changing. It is a measure of how sustainable a trend in prices is. This momentum can continue in an upward or downward trend, and it is measured by technical indicators. When prices begin to trend in the other direction, momentum has slowed.

Momentum trading is a strategy that follows these trends. Traders buy when prices are starting to rise and sell when they seem to have peaked and momentum has begun to reverse. This kind of trading follows the market, rather than buying low and selling high.