Momentum is a crucial part of trading, and participants in the market are always taking into account how fast price changes occur. Technical traders are especially keen on momentum. This is because momentum complements their trading strategy and further increases their trading confidence.
As a trader, knowledge on price momentum in the market should support your trading strategy, just as it does professional traders.
So how does it all go down? Read on and find out more about momentum, momentum indicators, and the potential benefits that are up for grabs with a thorough understanding of this concept.
What are momentum indicators
Momentum indicators form a section of the broader array of technical trading tools available for use by traders. These indicators are used on trading charts to display various facets surrounding momentum.
Most of the time, they are combined with other indicators as a way of refining trading signals sent out. This is mainly because momentum indicators, unlike trend indicators, do not show the direction of price movement.
Momentum indicators can reveal the strength or weaknesses of price changes. By doing so, they allow traders to go about investing with confidence as they are assured of an upward or downward trend as gathered from momentum indicators.
To better understand how momentum indicators work, you first need to have a basic understanding of momentum.
Momentum?
Momentum indicators, from their name, work around momentum. Momentum quantifies the rate of change that a price undergoes. This gives you an idea of how fast or slow the quantity of trading instrument shifts.
Since momentum is given by a rate of change in a parameter, the indicators then consider a timeframe during which such a change occurred. It then uses the information collected to plot a single line on a trading chart.
Momentum indicators are classified as oscillator type indicators because momentum indicators often work by sending out signals that assist traders in picking out the forces behind price movement. Such signals identify whether the market will continue moving in a certain direction or retract and diverge from the prevailing trend.
Even if a price is seemingly following an upward trajectory, you need to have a rock-solid conviction that it won’t give in and with it take away your investment. This way, if the price is expected to experience a reversal, you will then be prepared for what is to come.
There are three critical signals you need to be on the lookout for when using momentum indicators. They are outlined below.
· Moving average cross
The average closing price over a select number of days is the moving average. To be able to identify the moving average cross, first, add a moving average line onto your trading chart alongside the indicator. With it, you should be able to tell when the price crosses the moving average line.
The moving average cross is, therefore a signal telling you when to buy or sell. Typically, you can buy when the indicator crosses above the moving average and sell when it comes from above heading down past the moving average line.
The moving average cross, however, is not a foolproof indicator of when to buy and sell. One should follow the predominant trend in the market. Furthermore, you should first test out the signal before putting it to use on a live trade.
· Divergence
Momentum divergence comes in two forms. They may either bear bearish or bullish inclinations. In the case of a bullish divergence, the price drops, but the momentum indicator’s low points are appreciating in contrast to the former.
O the other hand, a bearish divergence will occur when the price is moving upward, but the momentum’s top-level is in decline. This indication shows that even though there is an increasing price for a stock, the number of people interested in buying is slowly falling and you are inclined to sell.
The two-sidedness characteristic of momentum divergence gives traders indications early on of a market that is about change direction. By following divergence signals, you will be able to tell how strong a price momentum is and whether it can keep up the pace and further add or reduce the value of a stock or other option.
Both scenarios offer critical insight into market behavior and further signal when you can enter into a trade. However, divergence should not be used as the sole sale indicator but rather in combination with other indicators to be able to build up a conviction for your trade signals.
· 100-line cross
Another signal provided by momentum indicators is the 100-line cross. Momentum indicators give this signal when the price action curve crosses the 100-line either moving above or below it.
Both scenarios point to bullish or bearish indications depending on where the direction the price is moving past the 100-line.
When the price moves down past the 100-line, commodity prices are in decline, and you may want to trade from a bearish position. The opposite holds when the price climbs past the 100-line.
Types of momentum indicators
There are plenty of momentum indicators out there. However, there are three key indicators popular among pro-traders and which, as a beginner, you ought to familiarize with.
1. Moving Average Convergence Divergence (MACD)
Pronounced mak-dee, MACD is one indicator popular with traders. The indicator follows a trend and shows the connection between the moving averages of a pair of prices for a stock or other trading instrument.
MACD can indicate price momentum oscillating between the two moving averages. During the process, the pair of moving averages will converge, overlap, and diverge from each other.
The indicator typically uses 12-day and 26-day exponential moving averages (EMAs). The difference between the two EMAs gives the MACD line plotted on the price chart. Combining this MACD with a 9-period EMA helps forecast price movement turns as the EMA acts as a signal line.
MACD is positive when the 12-day EMA value is above the 26-day EMA. It is negative when the conditions are rotated. When the two EMAs move away from each other, the MACD, in a similar fashion, moves away from its baseline.
A histogram usually accompanies the MACD indicator to disclose the difference between MACD and the 9-day EMA line. The histogram is essential for traders in that they can identify bearish or bullish conditions in the market.
For example, when the histogram is positive (lies above the 0-midpoint), but then begins to fall towards the midpoint. Such a situation alludes to a declining uptrend.
2. Relative strength indicator (RSI)
The RSI is another popular trading indicator in constant use today, more so in the day trading arena. As a part of the New Systems in Trading book by J. Welles Wilder, RSI indicates the momentum a trading instrument bears.
To do so, RSI takes into account the price of a commodity or stock and follows its upward and downward trend. How fast this rate fluctuates is indicative of the strength of its price action and, as such, may give you a bearing as to the direction the market follows.
While using an RSI, stocks are given a value between 0-100 and then compared against other parameters such as under bought or overbought values.
RSI often uses the values 70 and 30 as caution points. They indicate both overbought and oversold assets, respectively, and can even be reconfigured to suit the trader’s preference. For instance, you can set them to 80 and 20 to ascertain the trading decision and avoid hasty moves.
Its use by day traders is well-known and hence is charted following daily trading intervals. Nevertheless, shorter time frames are used to chart RSI when you are scalping.
3. Average directional index (ADX)
The ADX was designed as part of the Directional Movement System in conjunction with Minus Directional Indicator (DMI-) and the Plus Directional Indicator (DMI+).
Directional Movement Systems are meant to assist in measuring momentum as well as the direction a price is moving to. ADX is, however, derived from the aforementioned –DMI and +DMI. The pair are obtained after comparing two consecutive bottoms and high points.
When the ADX value goes above 25, it indicates a strong trend and none when it drops to below 20. If the ADX is falling from a high position, then the prevailing trend is coming to an end or weakening when the decline is sustained.
A rising ADX signifies an improving trend. When it increases by 4-5 units, then you can ride on the pattern to some meaningful gains. As the ADX line is related to the accelerating price movement, it tends to flatten when this trend indicator follows a constant slope.
Advantages of using momentum indicators
Momentum indicators are used to show the strength of price movements. Basically, if a robust upward trend up should hold out for even longer than another with weak tendencies. The former holds better investment opportunities for traders.
Additionally, these indicators pick out market reversal points. Through either bearish or bullish divergences, you will get a pretty good feel as to the interest that drives the price of a stock. The points between momentum and price movement are especially critical to recognizing market reversal points.
Nevertheless, momentum indicators are rarely used in isolation, and most times, do not serve as primary indicators. They indicate the strength of a trend but not where this trend is headed.
You will not get the direction of price movement from momentum indicators alone hence the need to combine other technical indicators to your trading strategy. Momentum indicators serve best as confirmatory tools complementing other indicators that signal the direction of price/ action.