Today, on this segment of "The Skinny On Options Math" Sosnoff and Tony Battista are joined by Jacob Perlman as Jacob explains the math behind these momentum moves. Tom started by saying how neat Jacob looked today. Tom joked, "You didn't ride your bike today? Because when you ride your bike you look 'challenged'."
What is the momentum of an underlying? Momentum is a tool in technical analysis, originally introduced in the same text as RSI. It is defined as the difference between the current price of an underlying and it's closing price at some fixed point in the past.
Technical analysts use the momentum of an underlying, often in concert with other technical tools, to look for "entry or exit signals." They view positive momentum as a sign that the underlying will continue increasing. Of course, unless an underlying is at an all time high or all time low, adjusting N (number of days) is able to change the momentum of a giving underlying from positive to negative.
Jacob explained that, "The momentum of an underlying requires you to also specify some specific time to calculate it with. It's the closing price from the past versus the current price." Jacob continued, "It's not momentum in the same sense that a physical object has momentum. It's just a word being used for a defined quantity on stocks, which is why I like calling it N-momentum (number of days momentum)." Jacob's goal was to determine whether or not stock momentum was useful.
Jacob said that momentum cannot have any predictive power. He said, "In fact, attempting to use whether momentum is positive or negative as a signal to execute a trade is exactly like trying to go long every time the underlying goes up and short everytime it goes down, except that you only do this when momentum crosses from positive to negative; still for Black-Scholes or Black-Sholes like underlyings, you expect infinitely many crossings adjacent to any given crossing."
Jacob's takeaway was that, "it was almost perfectly useless." Jacob's take was they are not useful and the user of such studies has only a 50/50 chance of being right. Check out the segment to get a deeper understanding of how momentum really works!