Summary
Momentum indicators are powerful tools that are used in technical analysis. In this blog, we discover what momentum indicators are and how they work. We'll also explore the most popular momentum indicators like the Relative Strength Index (RSI) as well as the Moving Average Convergence Divergence (MACD), among others.
In financial markets, momentum indicators are technical analysis tools that measure the rate of change in the price of an asset over a specific duration. Traders and investors use momentum indicators to identify the strengths and weaknesses of a trend. It can also help detect the potential points of reversal in the market. As valuable tools for insights into market dynamics, momentum indicators are typically plotted below the price data on charts.
Let us understand this better with an analogy. Essentially, momentum indicators in trading are like observing how cars behave on a racetrack. With momentum indicators, you can easily gauge the speed and strength of price movements, identify potential risks and areas of concern (typically introduced by oversold and overbought conditions), and spot trends of rapidly changing speed or acceleration that could ultimately influence your trading decisions.
Most common momentum indicators
One of the most common momentum indicators is the relative strength index (RSI). On a chart, the RSI assigns stocks a value ranging from 0 to 100. Analysts can then compare these values with other indicators, such as overbought or oversold levels. However, for a more comprehensive assessment, experts prefer to analyse the RSI on a daily timeframe and not an hourly one. Note that often there are instances when an examination of shorter hourly intervals can help determine the feasibility of an asset purchase in the short-term.
The relative strength index is calculated using the following formula:
| 100 RSI = 100 - ___________ 1 + RS Where, Mean of up closes for x days RS = ______________________________ Mean of down closes for x days |
In essence, the RSI serves as a critical tool that helps investors identify potentially highly rewarding setups with lower probabilities. Note that RSI is most effective when used in conjunction with crossovers with moving average in the short-term. Let us understand this better with an example.
Suppose you are combining a 10-day and a 25-day moving averages. While combining, you may notice that the crossovers closely aligned with instances indicate a change in direction. This happens only when the RSI falls within the range of 20-30 or 70-80. For you, these are clear signals of the RSI either being overbought or oversold. To simplify further, the RSI tends to predict reversals in a trend earlier than most other indicators, irrespective of whether it’s upward or downward.
Other than RSI, common momentum indicators also include:
- Commodity Channel Index (CCI): The CCI is a measure of the connection between an asset's standard deviation, its moving average, and its price. The values can either be positive or negative. While positive values suggest an above-average price due to potential bullish momentum, negative values show a below-average price due to potential bearish momentum.
- Williams %R: Also called the %R, this indicator oscillates between 0 and -100 measuring overbought and oversold conditions. While readings below -80 indicate oversold conditions, if the readings are above -20, it indicates overbought conditions.
- Average Directional Index (ADX): Despite the name, ADX does not measure the direction of a trend but rather its strength. The readings can range between 0 to 100, with a strong trend indicated by values of and above 25. For traders, ADX must be used in conjunction with other indicators to ascertain the presence of a trend.
- Rate of Change (ROC): ROC is used over a specific period to measure the percentage change in price which enables traders to identify the speed of price changes. And while an ROC on the upswing suggests bullish momentum, a falling ROC suggests bearish momentum.
- Momentum Oscillator: This oscillator compares the historical price of an asset from a specific number of periods ago with the current price and calculates the difference between them. The value of a momentum oscillator floats around a zero line. While positive values above this line suggest an upward momentum, negative values are indicators of downward momentum.
- Stochastic Oscillator: Over a specified period, the stochastic oscillator compares an asset's price range to its closing price. Here, the values are generated between 0 and 100. While readings above 80 indicate overbought conditions, readings below 20 are indicative of oversold conditions. As a trader, you should use stochastic crossovers as well as divergences to arrive at trading decisions.
- Moving Average Convergence Divergence (MACD): This is another popular momentum indicator. MACD follows trends and has two lines: the MACD line and the signal line. Traders using MACD need to look for crossovers between these lines to help identify potential signals of buy or sell. If you look at the MACD histogram, it displays the difference between the two lines, which can be crucial in assessing the strength of a trend.
In Conclusion
Momentum indicators act as powerful valuable tools empowering traders and investors to assess both the strength as well as potential reversals of market trends. However, for the most accurate results, it is always recommended to use momentum indicators alongside other technical analysis tools. One must also consider the other fundamental factors affecting the market to make the best trading decisions.