4. Visualize the momentum that leads market changes

Sand Storm! 2010: Act I, Scene 4; Changing Density is Momentum Divergence.

As on the prior page, density means the number of stocks within the area of one grid cell, and we are interested in how that density changes with time. As you might expect, the local velocities help provide that information. Instead of using the local velocities by themselves, we multiply the local velocity by the number of stocks to find the momentum in each grid cell. That is, momentum is the number density times the local average velocity. Therefore the high density in a grid cell near the center of the chart increases the weight of the low average velocity usually found there, to have larger effect. Similarly, the low density near the edges of the chart lowers the weight of the large velocities sometimes encountered out there, to have lower effect.

Now we can predict the change in density at an intermediate point between four neighboring grid cells from this momentum information. We add up the inflow and subtract the outflow to get the divergence, or net change. The idea is that momentum toward that intermediate point from one cell must be balanced by momentum away from that point toward other cells, or else the density at that point will increase or decrease. Think of the point as a country engaged in trade with its four neighbors. If the cost of all the imports is not the same as the revenue from all the exports, the net worth of the country must change with time (or other interesting things must happen.)

These points between the grid cells are shown in the Divergence Snapshot taken from the animation. You might note that these points lie between the tips of the arrows marking the grid cells in the static chart of the prior page. The divergence appears as green plus signs (+) or red minus signs (-) where stock density is increasing or decreasing, respectively. The size of a symbol represents the magnitude of the change. When the market is mostly moving toward lower return, there should be large red minus signs near the top of the chart and large green plus signs near the bottom. Similarly, when the market is mostly moving toward higher risk, red minus signs on the left are associated with green plus signs on the right. In the example static chart, the green plus signs are found in the upper left part of the chart, showing where stocks are going away from the red minus signs near the center of the chart. This corresponds to the global average velocity direction shown by the blue arrow in the upper left corner; stocks generally are moving toward higher return and lower risk at the time of this snapshot.

This concept is important for the momentum trader, who needs to know not only where the market is going (where to sell), but where it is coming from (where to buy). These terminal locations can be well separated, so tracing the velocity arrows in the previous Scene 3 might be misleading. That is, the DiligentInvestor econometric model treats this normal space as supporting a collection of sources and sinks, with flow of stocks from many of one to many of the other, but with no change in the total number of stocks. Using the ideas of consistent movement of individual stocks moving among and through particular locations in normal space, you can obtain a clear picture of current trends. Two such trends, and eventual limits to those trends, are discussed on the next page.

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