Imagine you throw a ball into the air.  What happens?  The ball keeps rising for a while—due to its momentum—and then it tumbles back to earth as gravity takes over.  This is the basic concept of this week’s featured indicator: Momentum Reversals.

Momentum is typically measured as a rate of change.  For a physical object, like the ball in the example above, the rate of change is simply the distance the thing travels in a given period.  For stocks, it’s the amount by which prices rise or fall in a specified time span.

For our purposes, we calculate the rate of change as the change in the price of the S&P 500 index over the past 252 trading days (or one year).  A positive value indicates that the price trend is up, and a negative value implies a downtrend.  We also place standard deviation brackets around this measure as a guide for how much prices have varied from the average over the past three months.

Here’s how the indicator works.  When the smoothed rate of change (orange line) crosses above the upper standard deviation bracket (top blue line) and then falls back below it, the indicator gives a negative signal.  And in the other direction, when the smoothed rate of change (orange line) crosses below the lower standard deviation bracket (bottom blue line) and then rises back above it, the indicator gives a positive signal.  These positive/negative signals can also be neutralized if the smoothed rate of change reverses back below/above the bracket it just crossed to trigger the positive/negative signal.

Historically, the return boxes on the indicator show that stocks have done very well after positive signals but far below average after negative signals.  You might notice that the indicator gives a lot of signals, but that is mainly by design due to the fast-paced nature of the indicator.  We want to catch a reversal in momentum, which generally happens quickly.  Plus, the abundance of neutral signals is a sign that many times there are false starts—momentum isn’t actually reversing—so the neutral signals at least keep us closer to the right side of the trend.

The bottom line is that much like a ball thrown into the air or a basketball shoved underwater, extreme momentum cannot be maintained forever.  Eventually, it reverses, and that same momentum takes the object back in the other direction.  We see this same dynamic play out in stock prices, which makes the Momentum Reversal indicator a powerful tool for measuring stock price action directly.

 

This is intended for informational purposes only and should not be used as the primary basis for an investment decision.  Consult an advisor for your personal situation.

Indices mentioned are unmanaged, do not incur fees, and cannot be invested into directly.

Past performance does not guarantee future results.