The complete guide to Momentum Indicator and pro tips for successful trading
No matter what time frame you trade on, it’s important to be aware of market sentiments and upcoming trend changes. This is where momentum indicators come in: they help traders identify breaking points in price development and serve as the basis for technical analysis. In this guide, we will explain how momentum indicators work and how to apply them for your trading strategies.
What are Momentum Indicators?
For any asset, price movements go as constantly changing phases of lateral consolidations and surges. Traders are interested in the moments of bursts, since they can make profit on impulse movements, especially towards the continuation of the trend.
A price surge in either direction is commonly called ‘impulse’ or ‘momentum’. This is a sharp downward or upward price movement with increased volume, and is often accompanied by breakouts of important levels with their subsequent retest. A sharp price movement (impulse) is usually represented by one or more candles on the chart with large volumes and bodies.
They can be revealed with the help of momentum indicators, and an oscillator is the most commonly used tool for that.
The Momentum Oscillator is displayed as a line on a trading chart. It has no upside or downside limits, but allows you to determine oversold or overbought limits. When it reaches very low or high levels (judged by the previous historical values), we can assume that the trend continues. When the underlying price gets too high or too low but it’s not confirmed by the Momentum indicator, we observe the divergence which may signify price pullback.
Momentum Indicator Example
On the intraday chart above, we can see Google stock price movements. One of momentum indicators, Rate of Change (ROC) reflects price fluctuations and trend reversals within a day. When it goes below zero, price nosedives, and when it suddenly goes above zero, asset price catches an uptrend.
But momentum indicators can also be very useful for defining long-term trend reversals and continuations. Look at the chart below:
On this chart, you can see the momentum indicator displaying price trends. For example, when it goes below the zero line, the stock price experiences a downward movement. When it gets close to 80 points and higher, the price is caught in an upward movement.
Momentum Indicator Calculation
The momentum indicator calculation formula was offered by John J. Murphy, a former technical analyst and the author of the book ‘Technical Analysis of the Financial Markets’. He says that ‘market momentum is measured by continually taking price differences for a fixed time interval’.
For example, to draw a 30-day momentum line, a trader needs to ‘subsctract the closing price 30 days ago from the last closing price’. It will give you a positive or negative value plotted around a zero.
Thus, the simplest calculation formula is:
Momentum = (Current closing price) - (Closing price n periods ago)
Here, ‘n’ is the number of selected periods.
How to Use Momentum Indicators
As a rule, Japanese candlesticks do not have shadows, and if they do, their size is insignificant (no more than 20%). Impulse candles, unlike reversal formations, often serve as the sign of a trend movement. After a retest of one or another key level, the price continues to move towards the main impulse, which is confirmed by momentum levels with their signals.
By using momentum indicators, you can perform different trading strategies. They are perfect for a short term since the impulses occur within the day and do not affect the overall trend in the long term. Let’s observe three different use cases (strategies) where momentum indicators can be exploited.
100 Line Cross
The 100 Line Cross can be used for both short and long-term trades. In this case, the momentum is calculated in pretty much the same way as we discussed above. But this version is measured in percentages, that’s why we have 100 on the scale.
Here’s how you should interpret the indicator to actualize the 100 Line Cross strategy:
- When the price goes above the 100 line, this is a buy signal - uptrend is on its way.
- When the price goes below the 100 line, this is a sell signal - a downtrend can be expected.
At the same time, the 100 line cross can be the subject to ‘whipsaws’ which means the price can touch the line and go back. That’s why it’s important to filter signals and confirm what’s indicated by the 100 line.If you see the stock trending lower the 100 line, you can open short (sell) deals.
To execute this strategy, you need to add a moving average to your chart: it will display the closing price over a previous number of days you set. This strategy involves:
- Buying when the momentum indicator crosses above the moving average from below.
- Selling when the momentum indicator crosses above the moving average from above.
However, this approach also comes with a few drawbacks. The major challenge here is the above-mentioned whipsaw when the indicator moves above the MA and drops below again. You should react quickly when it happens: make short trades when this situation happens. If the indicator suddenly gets above the MA, exit your short trade.
When you’re figuring out your perfect trading strategy, you can experiment with different lengths of moving average and momentum indicator settings.
Divergence happens when the price moves in one direction and the momentum indicator - in another. Look at the chart above: the price is growing but the momentum behind the traders’ buying power is slowing. If you get a sell signal, this bearish divergence can help you confirm it. It works in the opposite way, too. When you see the price going lower but momentum getting higher, you can seek for confirmation of the buy signal.
Note that divergence is never used separately from other strategies and approaches: it’s efficient only in combination with other trading instruments. You should also be aware of false signals produced by the indicator. For example, when the price rises but then moves sideways, the momentum indicator will surge and start dropping - this is a natural reaction. It means recently there has been a lot of price fluctuation, and now that the movement have calmed down it doesn’t necessarily imply a downtrend.
Momentum histogram is also based on price fluctuations over a certain period. It is evaluated relative to the zero line. The deviation can be both positive and negative, and the movement of these lines up or down is an indicator of a possible price deviation. This tool is quite informative on short-term timeframes, so it’s recommended for day trading.
Momentum histogram will notify the trader of a trend change by changing the color of the bars (or zone). For example, if we want to open a buy deal, we need to wait for the moment when the color of the histogram bars changes (in this case, from red to green). As a result, there may be a change in trading trend or a correction. When the histogram bars change from green to red, we can expect a downtrend.
It can also generate signals in the following manner:
- A sell signal is an increase in the momentum histogram and a sharp decline. The formation of such peaks is a signal to place a sell order.
- A buy signal is a falling line with a reverse upward movement. The formation of a lower peak is a signal to place a buy order.
Note that movements of histogram directly depend on the volatility of the instrument.
The Best 5 Momentum Indicators
Momentum is not the only indicator of impulse levels - there are also more advanced options that imply more complex calculations.They are based on additional criteria such as volume, opening prices, local extremes, resistance lines, etc. It is recommended to start working with Momentum and then experiment with complicating the tools used as you keep gaining experience.
Moving Average Convergence Divergence (MACD)
MACD is a momentum indicator that’s based on two moving averages: as a rule, default settings for them are 26 period and 12 period (though they can be customized). This indicator consists of the MACD line (difference between the 26 EMA (Exponential Moving Average) and 12 EMA) and the signal line (9 EMA).
How to interpret it?
- When the MACD line (blue) crosses the signal line (red) from below, you should consider buying an asset.
- When the MACD line crosses the signal line from above, you should consider selling an asset.
Look at the chart below:
Rate of Change
The rate of change displays the speed of price changes over a particular period. This indicator is calculated as a ratio between fluctuations in one variable against another. An asset with a high momentum will have a positive ROC while an asset with a low momentum will have a negative ROC.
Hence, decline of ROC is a sell signal, and growing ROC is a buy signal:
This momentum indicator helps traders analyze the current closing price of an asset over a certain period. It tracks both momentum and the speed of the market, but does not take volume and cost into consideration.
As a rule, stochastics serve to define oversold and overbought zones and keep in the range from 0 to 100. When the indicator goes above 80, this is called an ‘overbought’ zone. When it gets below 20, this is an ‘oversold’ zone:
Relative Strength Index (RSI)
RSI displays changes in prices and the speed of these fluctuations over a certain period. The indicator keeps in the range from 0 to 100. Traders look for divergences and points when the indicator crosses the central line (50).
When RSI gets above 50, it signifies a positive momentum. However, when the RSI exceeds 70, this can indicate an overbought market. At the same time, RSI crossing below 50 shows a downtrend momentum and when it gets below 30, the market may be oversold.
Average Directional Index (ADX)
This index was created by Welles Wilder as a part of the Directional Movement System. It measures both the momentum and direction of price fluctuations. Note that the ADX values of 20 or higher show that the market is trending or gaining momentum. When the reading is below 20, the market is moving sideways (‘consolidated’).
Tips for using momentum indicator
These recommendations will help you use momentum indicators with maximum efficiency:
- When choosing a timeframe, it is better not to use time periods shorter than half an hour or use additional filtering parameters, since the indicator gives a lot of false trade signals.
- It is important to take into account the average volatility for the selected trading instrument.
- When opening a trade, you need to set a stop loss at the nearest impulsive high or low on the selected chart.
- It is important to take into account the state of the market before the momentum appears - the speed of the resulting price movement is directly proportional to the strength and size of the subsequent rollback.
What Are The Advantages of Using Momentum Indicators?
Here are the reasons to use momentum indicators:
- They show the movement of price over a certain period of time that can be set up by a user. These indicators also can give you a hint on how strong price movements will be, no matter in which direction the price moves.
- Momentum indicators are an indispensable part of any trading strategy because they show the spots when the market can reverse. These breaking points can be identified by finding divergence between price movement and momentum.
- Since these indicators show the strength of price movements regardless of their direction, they work well combined with other trading tools, for example, moving averages. The latter show trends and price directions, in their turn.
What Are The Limitations of Using Momentum Indicators?
Before including momentum indicators into your trading strategy, you should consider a few crucial aspects:
- The momentum indicator does not add much information to what is depicted on the trading chart itself. In fact, if the price is quickly moving in a certain direction, you will see it on reading candles.
- The momentum indicator may give false signals. However, it is great for noticing minor shifts in buying or selling power, essentially through the use of divergence.
- This instrument can help you confirm your trading strategies, but it should not be the only tool to define signals - combination of indicators gives more reliable results.
Momentum indicators are trading tools that serve to identify traders’ buying or selling power, as well as the strength of price movements. These indicators are mostly calculated by measuring price changes over certain periods of time. They are commonly used for analyzing current and upcoming market trends, as well as overbought and oversold levels.
Although momentum indicators are very convenient and versatile, they alone should not be used to get trading signals. For more reliable results, traders should combine them with other tools for technical analysis. In particular, the ones based on volume and price level (because momentum indicators do not include these aspects).