How to use a momentum indicator?
A momentum indicator is a tool used in technical analysis to determine the rate of price changes. Traders can use it to confirm the current trend, find entry and exit signals, and predict potential reversals.
What is a momentum strategy?
A momentum trading strategy involves using the momentum of the current trend to buy or sell assets in order to maximize one’s returns. The strategy is based on the rationale that once a trend is established, it will most likely keep going for a while.
What is the definition of the momentum effect?
The momentum effect refers to the tendency of assets that performed exceptionally well or bad in the preceding months to continue moving in the same direction for a while longer.
What is a momentum indicator?
Momentum indicators are tools used in technical analysis to measure the rate at which an asset’s price changes over a specific period of time. These indicators are very useful in trading as they can identify whether the current trend is strong or weak. They are particularly helpful in bull markets as they generally last longer and occur more frequently than bear markets, which means momentum indicators have more data to give a more reliable analysis. However, it is better to apply them in addition to other tools as these indicators cannot identify the direction of the trend on their own. As for charts, any momentum indicator appears as a line on a graph below the main price charts.
Momentum divergences are differences between the directions of movement of a momentum indicator and an asset’s market price. For instance, if both the price of an asset and a momentum indicator are falling, but then the momentum indicator stops moving downwards or starts rising, then there is a momentum divergence.
Momentum divergences indicate that the momentum of the price movements is slowing down. This signals that the current market trend is likely coming to a close and might reverse soon. Momentum divergences can be bullish or bearish, depending on the direction of the initial price and momentum indicator movements.
Advantages of momentum indicators
Momentum indicators prove very valuable for traders who need to map out their next steps, as they can be used to identify multiple parameters:
- Reversal points. Momentum indicators can give traders estimates about when the market may reverse, which can be identified by measuring divergence between the momentum and the price movement.
- Trend. Since momentum indicators determine the strength or weakness of the trend, traders can use them to confirm the current trend and, by extension, the viability of their trading strategies.
- Entry and exit signals. When used with the inertia indicator, momentum indicators can help traders identify entry and exit signals. If both indicators move in the same direction, traders may receive an entry signal; but if the indicators diverge, traders should prepare to exit their trades.
- Direction of the market. Even though momentum indicators only provide information about the fluctuation of the price over a specific time frame, they can help establish the potential trajectory of the market if used in addition to other tools.
Types of momentum indicators
Relative Strength Index (RSI)
The Relative Strength Index, or the RSI, is a popular momentum indicator used to measure price changes and the speed at which they occur. This indicator works as an oscillator that swings back and forth between 0 and 100. If the indicator shows any divergences or crosses over the centerline (50), it signals an upcoming reversal of the current trend. The RSI can also help to determine whether an asset is overbought (70 or above) or oversold (30 or below), which allows traders to prepare their next moves.
Moving Average Convergence Divergence (MACD)
The MACD is the most well-known and widespread momentum indicator. It works as an oscillator representing the relationship between two moving averages — usually the 12-day and 26-day exponential moving averages (EMAs). The MACD is calculated by taking the 26-day EMA out of the 12-day EMA. The resulting line — the MACD line — is plotted on a graph alongside the 9-day EMA, which in turn acts as a signal line.
The subsequent movement of two lines when they overlap, converge, or diverge from each other indicates the current momentum, giving traders buy or sell signals. For example, if the MACD is below the signal line before they cross, the indicator gives a buy signal. In contrast, if the MACD crosses the signal line from above, traders can prepare to place a sell order.
Average Directional Index (ADX)
The Average Directional Index, or the ADX, is a momentum indicator that helps determine the strength and the direction of the current trend. Technically, traders use three different indicators at the same time: the ADX itself, the Minus Directional Indicator (-DI), and the Plus Directional Indicator (+DI).
The ADX line is plotted on the graph alongside both directional indicators, with values ranging from 0 to 100. The directional lines are used to determine the direction of the trend, and the ADX line measures its strength.
For example, the -DMI line above the +DMI indicates an uptrend, while the +DMI above its counterpart indicates a downtrend. The strength of the trend is determined by the values of the ADX line. If the values are higher than 25, the trend is strong. But if the ADX line drops below 20, the trend is weak.
Rate of Change (ROC)
The rate of change indicator, or the ROC, is a momentum indicator that measures the percentage change in the price of an asset over a particular period of time. It compares the current price of an asset with its price from a different, preceding time frame.
This indicator can help traders identify the direction of the market movement. If the ROC is positive, the market is bullish, and vice versa. If the ROC surges upwards, the price also experiences a sharp increase; but if the ROC plunges downwards, the price decreases just as quickly.
This momentum indicator is used to compare the current closing price of an asset with a set of its previous prices taken over a specific time frame. This gives traders information about the momentum and the speed of the market but doesn’t account for the current volume or the price of the traded asset. It is most commonly used to identify trend reversal signals.
A stochastic oscillator is plotted as a line on a graph and scaled from 0 to 100. If the oscillator rises above 80, it indicates that the asset is overbought. If it falls below 20, the asset is considered oversold. Knowing this, traders should prepare for potential trend reversals as an overbought asset will eventually be sold again, and vice versa.
2023-05-11 • Updated