Momentum indicators are technical analysis tools used to evaluate the strength or weakness of a trend in an asset by examining the direction, size and rate of change of price movements. Momentum indicators in technical analysts assess whether an asset’s recent price moves are accelerating or decelerating and find potential reversals or continuations of existing trends.
Momentum indicators give early signals of whether a trend is getting stronger or weaker, or whether a bear market is gaining impetus or a bull market rally is running out of steam. Traders then respond to these signals by either opening trading positions that move in line with the momentum, or by protecting their profits by closing positions in market trends that are about to reverse. This makes momentum indicators ideal for use in short-term trading strategies that aim to capitalise on uptrends or protect capital during downtrends.
Key among the momentum indicators that traders keep a close eye on are the Relative Strength Index (RSI), the Moving Average Convergence Divergence (MACD) indicator, Stochastic, Commodity Channel Index (CCI) and the Money Flow Index (MFI). Taken together, these different momentum tools give a complete spectrum view of the strength and power of recent price moves. The ability to master these key momentum indicators is an essential skill for any technical analyst and a critical component of any high-probability entry and exit trading strategy.
1. Moving Average Convergence Divergence (MACD)
The Moving Average Convergence Divergence (MACD) indicator is commonly used by stock traders to identify trends and momentum in the market. It is calculated by taking the difference between a 26-period and 12-period exponential moving average of closing prices.
- MACD line crossing above signal line indicates positive momentum and is a buy signal.
- MACD line crossing below signal line indicates negative momentum and is a sell signal.
As a momentum oscillator, the MACD will fluctuate above and below a centerline at zero. Traders use the MACD to time entries and exits, as crossovers signal a change in the direction of a trend.
2. Relative Strength Index (RSI)
The Relative Strength Index (RSI) is a momentum oscillator used in technical analysis to gauge the current and historical strength or weakness of a stock or market. It is calculated by taking the average of a stock’s gains over a specified time period, dividing it by the average of the stock’s losses over that same time period, and converting that into a ratio between 0 and 100. The RSI generates a number from 0 to 100, with readings above 70 indicating an overbought condition and readings below 30 indicating an oversold condition.
- An RSI above 70 signals an overbought market and potential downtrend reversal, acting as an exit signal for traders.
- An RSI below 30 signals an oversold market and potential uptrend reversal, acting as an entry signal for traders.
Traders will often look for bullish or bearish divergences between price and RSI to identify potential reversals. By analysing overbought/oversold levels and divergences, the RSI indicator helps traders determine when a stock is ripe for a reversal in direction.
3. Average Directional Index (ADX)
The Average Directional Index (ADX) is a technical indicator used by traders to determine the strength of a trend in a stock.The Average Directional Index (ADX) is calculated by smoothing the difference between the +DI and -DI directional movement indicators and then normalising the result to a value between 0 and 100.
- An ADX above 25 during a downtrend signals a strong trend and is an exit signal for traders.
- An ADX above 25 during an uptrend signals a strong trend and is an entry signal for traders.
Traders use the ADX to confirm the presence of a trend before entering trades in the trending direction. By quantifying trend strength, the Average Directional Index helps traders ascertain when a stock is exhibiting a strong enough trend to trade profitably. The higher the ADX reading, the stronger the ongoing trend.
4. Rate of Change (ROC)
The Rate of Change (ROC) indicator measures the speed of price movement over a set time period. It is calculated by taking the current price and dividing it by the price from ‘n’ periods ago. The ratio is then plotted as an oscillator that fluctuates above and below a centerline at 100. Traders look for crossover signals when the ROC crosses above or below the 100 line, which identifies a change in momentum.
- A high positive ratio signals high upside momentum and is an entry signal for traders.
- A low negative ratio signals low downside momentum and is an exit signal for traders.
The Rate of Change compares the current price to the past price to gauge how rapidly a stock is moving. Faster rising ROC reflects strengthening upside momentum, while faster falling ROC shows building downside momentum.
5. Commodity Channel Index (CCI)
The Commodity Channel Index (CCI) is an oscillator used in technical analysis to detect when a stock is reaching extreme high or low levels relative to its historical average. It is calculated by determining the difference between the typical price of an asset and its simple moving average, divided by the mean absolute deviation of the typical price. The CCI measures the current price relative to the mean price over a set period, with values above 100 indicating an overbought condition and values below -100 indicating an oversold condition.
- CCI crossing above zero into positive territory signals upside momentum, acting as a long entry signal for traders.
- CCI crossing below zero into negative territory signals downside momentum, acting as a short exit signal for traders.
Traders will often initiate countertrend positions when the CCI reaches these extreme high or low levels. By identifying overbought and oversold levels, the Commodity Channel Index helps traders determine when a reversal is on the horizon.
6. Stochastic Oscillator
The Stochastic Oscillator is a momentum indicator that calculates the position of the current price relative to the recent high-low range to identify overbought and oversold levels. It is calculated by taking the current closing price, subtracting the low of the lookback period, dividing by the high minus the low of the lookback period, and multiplying by 100. It uses two lines – %K and %D – that oscillate between 0 and 100. Traders look for crossovers of the 80 and 20 levels as potential trade signals.
- An RSI above 70 signals an overbought market and potential downtrend reversal, acting as an exit signal for traders.
- An RSI below 30 signals an oversold market and potential uptrend reversal, acting as an entry signal for traders.
The Stochastic Oscillator fluctuates as prices move through periods of high and low volatility, helping traders identify turning points in the prevailing trend.
7. Bollinger Bands
Bollinger Bands are volatility bands plotted above and below a moving average. They are calculated by taking a simple moving average of the price, then adding and subtracting a number of standard deviations away from the moving average. The bands widen during periods of high volatility and contract during periods of low volatility. The upper band provides resistance, while the lower band gives support.
- It indicates an overbought condition, when price hits the upper Bollinger band, traders receive a sell signal anticipating potential market reversal to the downside.
- It indicates an oversold condition, when price hits the lower Bollinger band traders receive a buy signal anticipating potential market reversal to the upside.
A move outside the bands signals increased volatility and a continuing trend. The closer the price moves toward the upper or lower band, the higher the possibility of a bounce off the bands in the opposite direction. Bollinger Bands adjust to market conditions by widening during volatile periods and contracting during calm periods.
8. Ease of Movement (EOM)
The Ease of Movement (EOM) indicator measures the relationship between a stock’s price change and its volume. It shows the ease with which price is moving based on volume. The EOM oscillates above and below a centerline at zero. It is calculated by dividing the distance between a period’s high and low by the volume for that period.
- An upward crossover of the EOM line indicates rising prices, signalling traders to open trades.
- A downward crossover of the EOM line indicates falling prices, prompting traders to close positions.
Traders look for crossover signals when the EOM crosses above or below the zero line, which identifies when momentum is shifting. The Ease of Movement indicator gauges whether volume is flowing in the direction of the trend or against it.
9. William %R
The Williams %R indicator measures overbought and oversold levels in a stock. It is calculated by taking the highest high minus the current close, dividing by the range from highest high to lowest low over the lookback period, and multiplying by -100. It is an oscillator that fluctuates between 0 and -100, where readings above -20 indicate overbought conditions and readings below -80 suggest oversold conditions.
- A buy signal forms when the Williams %R falls into oversold territory, forecasting an upward trend turnaround.
- A sell signal emerges when the Williams %R rises into overbought territory, predicting a downward trend reversal.
Traders often use Williams %R along with other indicators to confirm signals and increase the likelihood of accurate trend change predictions. Overall, Williams %R is a useful momentum indicator for determining exhaustion points and timing entries, but like all indicators it should not be solely relied upon.
10. Coppock Curve
The Coppock Curve is a long-term momentum indicator designed to identify major turns in the stock market. It calculates a 10-month weighted moving average of the sum of 11-month and 14-month rate of change oscillators. The indicator fluctuates above and below a centerline at zero.
- An upward crossover of the indicator from negative territory foretells a bull market, prompting traders to enter long positions at favourable prices.
- A downward crossover of the indicator from positive territory predicts a bear market, causing traders to exit short trades at optimal levels.
The Coppock Curve aims to generate only long-term signals, filtering out short-term noise. Traders watch for curve crossovers above or below the zero line to anticipate shifts in the primary trend. As a momentum indicator with a long-term focus, the Coppock Curve isolates the major turns by ignoring minor price fluctuations.
11. On Balance Volume
On Balance Volume (OBV) is a technical momentum indicator that uses volume flow to predict changes in stock price. It is calculated by taking the total volume for each period and adding it to a cumulative total if the closing price is up for that period, or subtracting the volume if the closing price is down.
- Volume is added to form a rising OBV line signalling upside participation, if closing price rises, indicating potential bullish momentum building.
- Volume is subtracted to create a declining OBV line showing distribution, when closing price falls, indicating potential bearish momentum developing.
Traders look for divergences between OBV and price to identify when momentum is shifting. On Balance Volume provides a running total of positive and negative volume to help traders spot changes in momentum.
12. Aroon Indicator
The Aroon indicator is a technical momentum indicator that measures the time between highs and lows over a given time period. It calculates the number of periods since the most recent 20-period high and low to gauge the strength of the current trend and potential for a reversal. It consists of two lines – Aroon up and Aroon down – that range between 0 to 100. The Aroon up measures the time since the last high, while Aroon down measures time since the last low.
- Readings above 70 signal strong uptrends for potential long trades
- while levels below 30 indicate strong downtrends to consider short positions.
The Aroon oscillator fluctuates between 0 and 100 as new highs or lows are reached to help identify shifts in the prevailing trend. Traders use Aroon crossovers to anticipate when existing trends are losing momentum and a reversal is developing.
13. Parabolic SAR
The Parabolic SAR (stop and reverse) indicator is used to identify potential reversals in the trend of a stock. It uses a parabolic curve that moves below prices in an uptrend and above prices in a downtrend. The Parabolic SAR indicator adjusts to volatility and helps traders exit long trades and reverse to short at potential tops.
- A SAR flip from below to above price signals uptrend exhaustion, prompting traders to close long positions.
- A SAR flip from above to below hints downtrend fatigue, alerting traders to take profits on short trades.
The SAR line’s parabolic movement accelerates when trends gain strength and decelerates as trends weaken. Crossovers signal potential reversals – SAR flipping from below to above price warns of upside exhaustion while changing from above to below hints at downside fatigue. Traders use Parabolic SAR to set trailing stops and capture profits during trending moves.
14. Detrended Price Oscillator
The Detrended Price Oscillator (DPO) is a momentum indicator that measures price after removing a moving average. It highlights cycles by filtering out the trend in prices. The DPO oscillates above and below a zero line just like other momentum indicators. Readings above zero indicate bullish momentum, while levels below zero signal bearish momentum. Traders look for crosses above or below zero to identify shifts in momentum.
- Go long when the Detrended Price Oscillator crosses up through zero, indicating the market is oversold and an uptrend follows.
- Go short when the Detrended Price Oscillator crosses down through zero, signalling the market is overbought and a downtrend ensues.
The Detrended Price Oscillator isolates the price cycle by eliminating trend influence to help identify turning points.
15. TRIX
The TRIX is a momentum oscillator indicator that shows the rate of change of a triple exponentially smoothed moving average. It is calculated by taking the percent rate of change of a triple EMA of the closing price to analyse momentum and identify potential reversals.
- Initiate buy orders when the TRIX oscillator pivots up through the zero level, foreshadowing further upward momentum.
- Initiate sell orders when the TRIX oscillator pivots down through the zero level, portending additional downward motion.
Traders look for crossover signals when TRIX crosses into positive or negative territory. Crossing above zero signals building upside momentum, while crossing below zero shows accelerating downside momentum. The TRIX indicator smooths price changes to isolate the true strength and direction of the trend.
What are momentum indicators?
Momentum indicators are technical analysis tools that measure the speed or strength of price movements over a specified time period. They are used to identify trends in stock prices and potential turning points when the momentum is shifting. Common momentum indicators include the Relative Strength Index (RSI), which measures the magnitude of recent price changes to evaluate overbought or oversold conditions, and the Moving Average Convergence Divergence (MACD), which uses moving averages to identify momentum shifts. Momentum indicators signal when a stock is gaining or losing strength, allowing traders to time entries and exits. For example, it suggests bullish momentum is building, if the RSI for a stock is moving upwards. By analysing momentum indicators in conjunction with other technical tools, traders aim to capitalise on emerging trends in stock prices.
How momentum indicators work?
Momentum indicators work by measuring the rate of change in a stock’s price over a specified time period. They calculate the difference between the current closing price and the closing price from a set number of days ago, such as 10 days. The greater the difference, the stronger the momentum is said to be. Momentum indicators help identify when a stock is overbought or oversold by showing when prices have risen or fallen too far too fast. On a chart, the momentum line oscillates above and below a centerline or zero line, with readings above the line indicating upside momentum and readings below indicating downside momentum. Traders use momentum indicators to identify trading opportunities when momentum is strengthening or weakening in a stock. The speed of the change in momentum signals potential turning points in the trend.
How to trade using momentum indicators?
To trade using Momentum indicators, identify overbought and oversold levels to find potential trend reversals ahead of time. Enter a trade when multiple indicators align, like when the RSI shows divergence from price as it exits overbought/oversold zones, the CCI turns up from the -100/-200 area, and the MACD histogram decreases. Set a stop loss below a recent swing low for longs or above a recent swing high for shorts. Move the stop to breakeven once momentum turns positive, and trail it higher as the trend continues. Take partial profits at the initial target, then let winners run while tightly managing risk. Following momentum indicators help traders enter on pullbacks at the start of new trends for maximum gains.
What are the advantages of momentum indicators?
Momentum indicators offer five benefits for traders looking to capitalise on market swings. First, they identify trend reversals early, allowing savvy traders to enter ahead of the crowd. Second, momentum oscillators highlight overextended conditions where a pullback or reversal occurs. This enables traders to anticipate potential exhaustion points. Additionally, momentum indicators provide confirming signals when used in conjunction with other technical analysis tools, giving traders greater confidence in trade signals.
They also reveal when market momentum is accelerating versus decelerating, helping traders gauge trend strength. Moreover, by smoothing out volatility, momentum indicators assist in clearly identifying significant swing points and areas of support/resistance. Finally, momentum oscillators complement trend-following indicators, candlestick charts, and other tools by providing additional perspectives on market conditions. For traders seeking high probability setups, using momentum indicators in combination with other analysis techniques offers an edge.
What are the limitations of momentum indicators?
The limitations of Momentum indicators are they generate false signals during periods of market volatility, leading to losses if acted upon. They are also slow to react to abrupt trend changes, causing traders to miss out on emerging opportunities. Divergence between price and the oscillator is another drawback, as it signals a reversal that doesn’t materialize right away.
Additionally, momentum indicators rely on historical data which becomes outdated quickly in fast moving markets. Since they oscillate between overbought and oversold levels, timing entries and exits are challenging. And using momentum indicators alone without other confirmation increases risk, so they should be combined with additional analysis. Understanding these limitations is key for traders to use momentum oscillators effectively as part of a robust trading plan.
How reliable are momentum indicators?
Momentum is a useful indicator of the strength or weakness of a stock’s price during trending. Momentum indicators are technical analysis tools that help traders identify the speed and direction of price changes in a market or stock. While momentum is a powerful tool for timing entries and exits, it should be used in conjunction with other technical indicators to confirm signals.
Momentum indicators work best in trending markets and produce false signals during periods of consolidation or ranging. Overall, momentum provides valuable information about the underlying health of a stock’s price action, but traders should employ prudent risk management when using momentum signals. Though not infallible, momentum remains an insightful method for gauging market sentiment and the potential for continued movement in a stock’s price.
What is the role of divergence in momentum indicators?
Divergence plays a key role in momentum indicators for technical analysis in stock trading. Divergence occurs when the price of a stock and its momentum indicator are moving in opposite directions. For example, this signals bearish divergence, if a stock is making new highs but its momentum indicator starts trending lower. Divergence usually indicates that a reversal in the price trend is imminent. Traders watch for such divergence to help time their entries and exits in stocks. Overall, tracking divergence allows traders to detect shifts in market sentiment and weakness in the current price trend ahead of the crowd. Though not a definitive signal on its own, divergence is a powerful tool when combined with other indicators to gauge turning points in stock prices.
Are momentum indicators useful for intraday trading?
Yes, Momentum indicators are very effective tools for intraday traders to capitalise on short-term price movements in stocks. Indicators like the Relative Strength Index (RSI) and Stochastics oscillators allow traders to identify overbought and oversold conditions on intraday time frames. Momentum oscillators help traders confirm the strength of breakouts and the start of new trends, when used with moving average crossovers. However, momentum indicators whipsaw more frequently during volatile intraday trading, generating false signals. To compensate, intraday traders often use tighter stops or smaller position sizes when trading off momentum signals. Overall, momentum remains insightful for very short-term swing trades, but requires prudent risk management given the noise and volatility in intraday price action.
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