The prices of stocks and securities in the financial markets are constantly fluctuating. The rise and fall of these prices is termed volatility, and you can use volatility indicators to better understand how the market may move. However, if you want to get more clarity on the rate of change of prices, you need to use momentum indicators in your technical analysis of securities.
In this article, we explore the meaning of momentum indicators, look at some examples of momentum indicators and see how you can use momentum indicators in your strategy.
What is a momentum indicator?
Momentum indicators are technical analysis metrics that enable traders to analyse the movement and strength of price trends over time. This is regardless of the actual direction of price movements. They are specially employed by market traders, investors, and analysts to identify price reversal points.
High momentum means that the stock price is rising or falling rapidly. This means the prevailing trend is strong. On the other hand, low momentum means the stock price is trending in either direction quite slowly. This may indicate some level of indecision in the market. Momentum indicators can help you analyse the strength (or momentum) of the prevailing trend.
Momentum indicator formula
More often than not, you are not required to calculate momentum manually. It can be done using investing websites, portals, and software. However, it is vital to know about the calculation procedure and its various components to be on top of the momentum and trend insights.
For measuring momentum indicators, you can adhere to the following steps:
- The first step involves dividing the present market closing price by a previous period’s price
- You can multiply the resulting number by 100
The formula for momentum indicators is:
Momentum indicator = (Present closing price)/(A previous period's price) × 100
Types of momentum indicators
Depending on the type of data used and how the momentum is represented, there are different types of momentum indicators that you can use to create a trading strategy. Some examples of momentum indicators commonly used in short-term trading include the following:
1. Moving Averages (MAs)
Moving averages eliminate wrinkles in the price data over time. The Simple Moving Average (SMA) gives equal weightage to all past price data, while the Exponential Moving Average (EMA) prioritises recent price changes. Moving averages can act as momentum indicators if you compare the current price with the MA line. If the current price is above the SMA and if the EMA is increasing, the momentum may be high (and vice versa).
2. Relative Strength Index (RSI)
The RSI is another reliable momentum indicator that measures how quickly and how much the price of a stock or security has changed recently. It has a value of 0 to 100, with values below 30, meaning the asset is oversold, and values above 70, meaning the asset is overbought. You can use the RSI to gauge momentum by checking its direction. An upward RSI trend suggests increasing momentum and indicates potential buying opportunities (and vice versa).
3. Moving Average Convergence Divergence (MACD)
The MACD is another strong momentum indicator that compares two EMAs — generally the 26-period and 12-period metrics. You can use the MACD to identify periods when the upward or downward trend has a high momentum and plan your trades according. If the MACD line (which measures the difference between the two EMAs) moves away from the signal line (which is the MACD line’s 9-period EMA), the momentum is high (and vice versa).
4. Bollinger bands
Bollinger bands are also momentum indicators that can help you identify how strong or weak the market trend is. The bands plot the SMA of a stock or security and the positive and negative standard deviations from the SMA. A widening of the bands indicates increased market volatility and potentially more momentum. Conversely, when the bands shrink, the momentum may be decreasing.
How to use momentum indicators?
You can use momentum indicators in your strategy in different ways. Some effective techniques include the following types of momentum indicator strategies.
1. Momentum trading
In this strategy, you take a long position in securities that are bullish and a short position in those that are bearish. You can use momentum indicators to identify how strong or weak a trend is before deciding whether or not to use it to initiate a trade. It is advisable to capitalise on a strong trend and ignore the weak ones.
2. False breakout
A false breakout occurs when the price seemingly breaks out of a prevailing resistance level, only to reverse again. This occurs because the momentum is insufficient to drive the price upward continuously. You can use momentum indicators in your strategy to identify periods of inadequate momentum and plan your trades accordingly.
3. Flat top breakout
A flat top breakout is a classic momentum indicator-led strategy. The flat top in this case refers to a strong resistance level that the price cannot breach for several trading sessions. However, the bullish volume continues to build. So, if the price manages to break out, the accompanying momentum may be high enough to sustain the upward trend.
4. Bull or bear flag
A flag pattern represents a period of consolidation during a strong uptrend or downtrend. By using momentum indicators, you can confirm the formation of a flag pattern if the momentum temporarily dips. This can help you plan your entry when the price breaks out of the consolidation channel.
Advantages of momentum indicators
Now that the meaning and calculation of momentum indicators are clear, let us take a look at their advantages. Momentum indicators encapsulate price changes in an asset over a given period. They measure how strong or how weak a trend is. In addition to this, momentum indicators are a direct aid to market participants, helping them make smart investment decisions.
It is key to remember that momentum indicators do not consider the direction of price movements. For this reason, it is recommended to use these metrics along with other technical analysis indicators like candlestick chart patterns.
Limitations of momentum indicators
Even with numerous benefits and high reliability, momentum indicators do have some drawbacks, which are discussed below:
- Momentum indicators do not have fixed limits. Thus, overbought and oversold levels must be set individually for each stock.
- Extreme prices (too high/too low) in the indicator’s starting window can distort the indicator.
- Indicator movements are often unpredictable and inconsistent.
Thus, even though momentum indicators are useful and important in the financial market, they must be used alongside other indicators to reliably and confidently identify trends and trend reversals.
Conclusion
These momentum indicators can be instrumental in how you create and execute your trading strategies in a trending market. You can scale these metrics across different timeframes to finetune your strategy as needed. For instance, if you want to close your trades within the same session, you can use these metrics as intraday trading indicators along with candlestick charts. This will help you make informed decisions about when to enter or exit the market.
