Whether you trade forex or explore profitable opportunities in the stock market, it is challenging to make money only using fundamental data. Therefore, it is pertinent to employ tools that present price activity and market data to improve the odds of profitability. Day traders rely on multiple technical indicators to identify market trends. This piece discusses a few most commonly used momentum indicators in detail.
What Is Momentum Indicator?
The momentum indicator is a technical analysis technique that determines a stock’s price strength. Momentum quantifies how fast stock prices rise or decrease. Traders use momentum indicators in conjunction with other tools and trend indicators to make an informed trading decision.
A stock’s price’s Momentum measures its rise or decline. It is well-known that momentum indicators are pretty helpful in trending markets since markets rise more frequently than they decline. In other terms, bull markets outlast bear markets most of the time.
Average Directional Index (ADI), Relevant Strength Index(RSI) and Moving Average Convergence Divergence (MACD), Rate of Change (ROC), and Stochastic Oscillator are some common momentum indicators.
How to calculate Momentum Indicator?
A stock’s Momentum is the difference between the current and previous closing prices. Technical Analyst Markets John J. Murphy plots a 10-day momentum line against zero-line.
We can use the following formula for calculating the momentum indicator.
Momentum = Current price – Closing price “n” days ago
Momentum can have both positive and negative values. Most traders and analysts use 10-day movement to gauge a stock’s momentum. The zero-line represents the stock’s trendless or sideways movement. The momentum line disperses away from zero when the stock’s momentum grows.
If the stock’s current price is higher than ten days ago, the positive number will be over the zero line. If the current price is below the 10-day price, the negative momentum value will be below the zero-line.
Look at the chart below to see how the RSI momentum indicator predicts price fluctuations.
Understanding Divergence
Divergence often signals the end of a price trend and the beginning of a new one. The divergence occurs when the stock price movement and the indicator disagree. A bullish divergence occurs when price and momentum move in opposite directions, while a bearish divergence occurs when the price and the momentum indicator move upwards. Price retracements are more likely to incur during price divergence.
Divergence helps traders identify and respond to price fluctuations. It signals a shift in the market, and investors must respond. No certainty of reversal exists. So, traders can decide to hold, sell, or partially book profits as the market moves.
Trending Momentum Indicators
Traders can use several momentum indicators. However, below are a few most used momentum indicators.
- Moving Average Convergence Divergence (MACD)
Moving Average Convergence Divergence (MACD) involves two indicators. It creates an oscillator by subtracting the longer average from the shorter average, the MACD’s primary indicator. A moving average converges, overlaps, and moves away from another to represent momentum.
The MACD uses two moving averages, as stated previously. However, it is up to the trader or analyst to choose between the 12-day and 26-day EMAs. In this way, a MACD line can operate as a signal line to detect price movement turns.
The MACD’s histogram shows the MACD line’s relationship to the 9-day EMA, which is crucial. Positive histograms above the zero-midpoint but falling towards the midline signals a deteriorating trend. On the other hand, a negative histogram below the zero-midpoint line but climbing towards it suggests a diminishing downtrend.
Image Source: Investing.com
- Relative Strength Index (RSI)
RSI is another popular momentum indicator that most traders prefer to use for technical analysis. The RSI is an oscillator that measures price fluctuations and their pace. The indicator oscillates between 0 and 100.
Traders and analysts can notice signals by looking for divergences, failed oscillator swings, and indicator crossings above the centerline.
While the RSI figures rising above 50 suggests a positive uptrend momentum, the RSI values of 70 or more frequently indicate overbought situations.
Similarly, RSI values below 50 signal a negative decline, while RSI values below 30 indicate possible oversold circumstances.
Image Source: Investing.com
- Average Directional Index (ADI)
It might be unfair not to mention the usefulness of the Average Directional Index (ADI) either. Welles Wilder created the Directional Movement System (DMS), including the Negative Directional Indicator (-DI) and positive Directional Indicator (+DI).
To calculate the ADX, you need to take smooth averages of the +DI and -DI, which results by comparing the two recurring lows and their relative highs. The Directional Movement System’s index measures the strength of a trend independent of its direction. An ADX rating of 20 or higher confirms a trend. However, any value below 20 is directionless.
Image Source: Investing.com
- Rate of Change (ROC)
Rate of Change (ROC) is another momentum indicator that gauges the percentage change between two prices. The ROC indicator is displayed against zero, moving upward for positive price changes and downward into negative territory when the price falls. The indicator detects centerline crossings, overbought/oversold conditions, and divergences.
Image Source: Investing.com
- Stochastic Oscillator
Traders use this momentum indicator to compare a stock’s current closing price over time. It measures the market’s pace and momentum without regard to volume or price. Stochastics oscillates between 0 and 100 and help detect overbought and oversold zones. This indicator displays an overbought zone when it is over 80 and an oversold area when below 20.
Image Source: Investing.com
How to trade using Momentum Indicators?
Momentum indicators help spot trading indications. They also assist analysts in validating trades based on price movements, such as breakouts and pullbacks. Traders can utilize momentum indicators in the following ways:
Crossovers: When momentum indicators pass through the centerline or other lines, the activity is called crossovers. Cross overs generate trade signals. For instance, the MACD Line crosses the centerline (zero line). Types of crossovers:
Signal line crossings are a typical MACD signal. A bullish trend develops when the MACD crosses the signal line on the upside. A negative trend happens when the MACD goes down and passes below the signal line.
Center Line Crossovers: A bullish trend occurs when the MACD crosses above zero-line. This happens when the stock’s 12-day EMA crosses over the 26-day EMA. A negative trend occurs when the MACD indicator intersects the zero line and swings lower. However, a trend’s strength may define its life as it may last a few days up to a month.
Alternative strategy:
It is best to enter and exit a position using one or two indicators. To quarantine a trend or entry point, use RSI. For example, the RSI can differentiate entry points from the Trend. Not to mention, the RSI reading should be above 70 during uptrends and above 30 during downtrends.
Trade can also use MACD to exit. For example, MACD can track stock losses in trading trends. If the Trend rises, you can short a position as soon as the price falls below the line. Similarly, traders can use other indicators for intra-day trading besides employing momentum indicators.
Pros and Cons of Using Momentum Indicators
While momentum indicators are pretty helpful in technical analysis, they can also sometimes be a source of inconvenience. Below are some pros and cons of using momentum indicators.
Pros
- Momentum indicators reveal an asset’s price trend. They also assess the price movements’ strengths and flaws.
- Momentum indicators enable users to make informed trading decisions. In other terms, they assist you in determining market entry & exit points. Price divergences identify the signals.
- Momentum indicators work pretty well for trend confirmation.
Cons
- Momentum indicators can be misleading when used in isolation.
- Newbies might find it challenging to understand and interpret them.
Bottom line
Momentum indicators are helpful to identify the best time to enter or exit a trade based on price momentum. Traders and analysts use momentum indicators in conjunction with other trend-following indicators as additional confirmation.
Since all traders don’t have the same level of experience and expertise, the urge to make quick money, especially when trading a small amount can often end up in catastrophic losses. If you’re good at trading and looking to get funded with a large capital, check out Traders Central’s funding plans.
Frequently Asked Questions (FAQs)
What is momentum trading?
Momentum trading is a method that aims to enter the Trend as it gains momentum. In simple terms, momentum is the tendency of a price trend to rise or fall for a period, generally considering both volume and the price.
Why is momentum necessary in trading?
Prices follow an upward or downward trend, and the momentum indicator shows the strength of a trend. It is also a leading indicator, as it generates buy & sell signals, helping traders open an appropriate position.
How does Trend differ from Momentum?
While the momentum takes account of a stock’s annual performance (i-e past twelve months), the Trend Following macro style element examines the contract’s performance over the last six and twelve months and takes an average.