Momentum indicators: do they work?

The 4 Momentum Indicators Every Trader Should Know About

New traders constantly search for the holy grail of indicators that may give them the best chance of beating the market. As they progress, they realize that depending on the trading styles and state of the market, not all indicators work.

Today, we will be sharing some of the most loved momentum indicators out there by both new and experienced traders, and give an insight of how it works, and importantly, why is it in the toolbox of most experienced traders.

What Are Momentum Indicators?

Momentum indicators are used by traders to get a better understanding of the speed or rate at which the price of a security changes. These indicators can help identify when buying or selling pressures are stronger, but they don’t work to determine the direction of movement, only the timeframe in which the price change is occurring.

Suppose you’re looking at a stock that has been experiencing a bullish trend for many months. You see that it suddenly reverses and moves downwards, but this seems like an anomaly to you—you believe that it’ll continue climbing up in the future, so you buy shares of the stock. Fundamentals and market sentiment aside, price action alone does nothing much to give your trade a confirmation bias. Momentum indicators can help give extra confirmation points for these types of trades.

 Momentum values usually range between zero and 100, with a value of zero being no momentum and a value of 100 being all the momentum. Momentum indicators are best utilized as an additional indicator in order to confirm and/or predict reversals in trends, as they can show divergence between actual price movements and momentum movements – specifically when they stop moving together.

Here it’s a beautiful animated video that will support you in understanding better the momentum indciators.

We shall share the 4 most loved momentum indicators that is in the war chest of most traders.

1.     Moving Average Convergence Divergence (MACD)

There are many different indicators that traders use to measure the momentum of a security, but one of the most popular is the Moving Average Convergence Divergence (MACD).

The MACD is an indicator that uses two moving averages – typically the 12-day and 26-day exponential moving averages (EMAs) – to generate an oscillator. This means that it shows momentum as it oscillates between moving averages as they converge, overlap, and move away from one another.

 MACD can be used with almost any type of security, but it is most commonly used with stocks and forex charts. There is a lot of flexibility in how a trader chooses to use the indicator. Typically, the 12-day EMA and 26-day EMA are used to determine what trends indicate when a stock or currency will change direction. When these values cross each other, it indicates that momentum has shifted, which can help a trader determine when to initiate a trade or exit an existing position.

 In addition to visualizing price movement changes, MACD also generates signals based on its value relative to its signal line. When the MACD line crosses above its signal line, it indicates that momentum is increasing. Conversely, when the MACD line crosses below its signal line, it indicates that momentum is waning.

2.     Relative Strength Index (RSI)

 Another popular momentum indicator is the Relative Strength Index (RSI). It is an oscillator that fluctuates back and forth between zero and 100. Signals can be spotted by traders and analysts if they look for divergences, failed swings of the oscillator, and when the indicator crosses over the centerline.

If RSI is above 50, it signals that prices are in an uptrend, though RSI readings above 70 often signal overbought conditions.

If RSI is below 30, it signals that prices are in a downtrend, though readings below 50 indicate oversold conditions.

 Overbought and oversold readings for RSI work best when prices move sideways within a range as opposed to trending up or down. In a sideways market, traders should pay attention to how quickly prices are increasing or decreasing in order to determine whether RSI is reaching extreme levels. With regard to long-term performance, prices that increase faster than their historical average indicate an overbought condition. Likewise, a price decrease that exceeds the security’s historical volatility signals an oversold condition.

3.     Stochastics Oscillators (Stoch)

 Momentum indicators, like stochastics, measure the speed and direction of stock price movement. Stochastics, or Stochastic Oscillator, is a momentum indicator that oscillates in the range of 0 and 100. A simplified version of the stochastics oscillator can be calculated using the SMA (simple moving average) and the closing price, which will then produce two lines on their own: the %K, which is the fast-moving line, and the %D, which is the slow-moving line. The %K goes above 80 when it is overbought and below 20 when it is oversold, and the %D goes above 80 when it is overbought and below 20 when it is oversold.

There are three main types of momentum indicators: Fast Stochastics, Slow Stochastics, and Full Stochastics. Each one of these indicators has its own interpretation, with each one being used to analyze different patterns in stock market data.

 Stochastics help in identifying the overbought and oversold zones by measuring the speed of price change of a stock. The faster price changes from low to high and vice versa the more overbought or oversold the market is considered to be. Stochastic is used for comparing the current closing price of a stock over a period of time with its moving average.

4.     Average Directional Index (ADX)

The Average Directional Index, or ADX, is a technical momentum indicator that is used to help in measuring both the momentum as well as the direction of price movements.

 There are 2 main values pertinent to note in the ADX: the Plus Directional Indicator (+DI) and the Minus Directional Indicator (-DI). The +DI helps identify whether the market is trending positively or negatively while the -DI identifies whether the market is trending positively or negatively.

 The ADX combines these two indicators by taking their values and averaging them out. Traders should note that an ADX reading of 20 or higher indicates that the market is trending and for any reading less than 20, the market is viewed as “directionless” or consolidated.

 The ADX is considered overbought when its value is above 70 and oversold when it is below 30.

Divergence? Why Should We Be Watching That?

While the indicators above are great, and are valuable assets to use in the trading battlefield, great traders often seek to determine and spot divergences, and couple them together with the indicators. Some even use divergence on what’s show on indicators and price action as certain tell-tale signs.

But why is that? When price is trending strongly and momentum is high, it usually shows that there are no divergences occurring. When there is divergence between the price and momentum indicator, it gives a sign that there may be a possible reversal, as the current trend may be coming to an end.

 A bullish divergence occurs when price moves downward while momentum moves upward. A bearish divergence occurs when prices move upward while momentum moves downward.

Divergence can also occur within both rising and falling markets. 

Divergence watchers, especially the experienced traders, know that what the spotted divergence means, is probably a foresight that something is changing, and does not mean 100% that the current trend will change or reverse completely. However, it alerts one to start watching more clues on other indicators to confirm a point, and utilise the best strategy to have a winning trade.

 The image below shows the examples of how divergences in the momentum indicator and price action leads to certain action, or flaccid action in total. Traders also watch for extent of divergence that happens, while watching closely on the momentum indicator’s signals as well.

Our Takeaways

Momentum indicators are a useful tool for traders because they can provide insight into the stock’s buying or selling momentum. As traders do get caught up in the emotions of seeing price action overtake their screens, it’s helpful to have indicators that actually play that part to give signals where price action changes are coming.

 To experienced traders, momentum indicators work well as a confirmation tool, but not as a standalone trading strategy. The forward nature of such indicators, when paired with volume action, is also possible and very much popularised as a useful combination among trading experts.

 Active inclusion of extra clues, such as divergences, as seen above, helps to give extra confirmation and increase the winning probability of the trade. This happens when highlighted divergences between price movements and momentum readings, actually signal traders to see where trends may be losing their strength.

 For new traders, the advice is to slowly build and use these indicators together, and there shouldn’t be a reliance on just one indicator alone for your trade decision-making process. Trade on and good luck!