Last Updated on 14 June, 2021 by Samuelsson
Most traders aim to trade in the direction of straight and try to capitalize on the continuance of an existing market trend or the emergence of a new one. To achieve this, they make use of the momentum strategy signals. For example, a trader can identify the strength of a price movement by monitoring any of those indicators that can tell about the momentum of the price.
But what are these indicators, and how do you implement the momentum strategy signals. These and many more we intend to explain shortly. In the post, we will cover the following topics:
- What are momentum strategy signals?
- How does the momentum strategy work?
- Advantages of the momentum strategy
- Types of momentum indicators
- What is the best momentum indicator?
- How do you use momentum strategy?
What are momentum strategy signals?
The momentum approach to trading aims to capitalize on the continuance of an existing market trend. It is an approach that is used to trade along the direction of price momentum. The momentum strategy signals, therefore, are indicator signals that are used to identify price momentum and trade in that direction.
Traders use those signals to identify where the price is headed in the nearest future, as well as to know when to enter a trade. Some of those signals can identify a change in the direction of price movement by observing the change in momentum. Such signals can tell you when to anticipate a price reversal so that you trade in that direction.
Most times, the indicators used to generate momentum strategy signals are members of the oscillator family of technical indicators. But other indicators that are not technically regarded as oscillators can also be used to show price momentum and potential reversals. Whatever the indicators, one common thing they have is their ability to measure the momentum behind price movements for the underlying financial asset over a period of time.
An interesting thing about the momentum strategy signals is that they can be used in any financial market. Apart from showing the price momentum — their ascent and descent — some of them show overbought and oversold levels, which may indicate potential reversal signs. However, more prominent reversal signals are the divergences, which show that the indicator and the price momentum are out of sync.
Most of the indicators for the momentum strategy are placed in the indicator box under the price chart, instead of overlaying the price, so you need to visually trace the indicator’s movement to the price action to interpret what is happening with the price. Some traders add a smoothed moving average with the indicator to improve their interpretation of the indicator signals and understand imminent trend changes.
How does the momentum indicator strategy work?
If you are familiar with classical physics, you would know about the term momentum in Newton’s first law of motion, which states that an object in motion tends to stay in motion until an external force is applied to it. Bringing that concept to the financial market, you can say that a price in motion tends to stay in motion until it meets a formidable resistance that can force it to reverse. But before the reversal starts, some momentum indicators must have shown the signs of diminishing price momentum.
Generally, the momentum indicators try to compare where the current price is in relation to where it was in the past, but different indicators use different formulas and calculations to achieve that. Furthermore, how far into the past the price comparison is made depends on the number of periods (n) the trader chooses. But what makes the momentum indicator positive or negative is majorly the position of the price in relation to an n-period in the past. Thus, if the current price is higher than the price was in the past, the momentum indicator is likely to be positive, but if the current price is lower than the price was in the past, the indicator will likely show a negative momentum.
So, with a momentum strategy, you aim to go long on whatever market you are trading — stocks, futures, exchange-traded funds (ETFs), Forex, or cryptocurrencies — when the market is in an uptrend and showing strong upward momentum, while you go short when the market is in a downtrend and showing strong downward momentum.
As you know, irrespective of the trend direction, the price moves in impulse and pullback swings. Swing traders who use the momentum strategy signals would always want to get into the next impulse wave after a pullback has ended. Most of the time, they make use of momentum reversal signals to spot when the pullback is over so that they can jump into the next impulse wave.
Advantages of the momentum trading strategies
There are many advantages of the momentum strategy signals, and here are some of them:
- They show the strength of price movements over time, regardless of whether the price is moving up or down.
- By showing price overbought/oversold levels and divergence between price movement and momentum, they can help traders and analysts to spot when the market is losing momentum and is likely to reverse.
- They work very well when combined with other technical indicators that show trend directions, such as trend lines and moving averages, because momentum indicators only show the relative strength of price movements without indicating the direction of the price movements.
Types of momentum indicators
There are different types of momentum strategy indicators. While we won’t go into details to explain how each is calculated and interpreted, we will list the common indicators you can use to get momentum strategy signals. The momentum indicators list include the following:
- The momentum indicator or simply the rate of change (ROC)
- The relative strength index (RSI)
- The commodity channel index (CCI)
- William %R:
- Moving average convergence divergence (MACD)
You may ask: Is MACD a momentum indicator? Well, MACD is a trend-following momentum indicator that shows the relationship between two moving averages of a security’s price. While many traders tend to use it to identify a trend, it can also be used to access the price momentum, as it swings above and below the centerline and can show divergences
So, how do you interpret the momentum indicator? It depends on the specific indicator you are using. But generally, when the indicator line or histogram is rising, the price is gaining momentum, especially if the indicator has crossed the centerline. The opposite is the same for a declining indicator line. There are also divergence signals, and some of the momentum indicators also show overbought/oversold levels.
What is the best momentum indicator?
Traders are different and have different personalities. While some like the RSI or stochastic, others may like OsMA, Williams %R, CCI, or MACD. Each trader uses whatever set of indicators they feel can give them what they want. However, they may prefer one momentum indicator for forex and another for stocks.
So, there is no best momentum indicator. It all depends on what you want and the market you are trading. You may feel that one indicator, say stochastic, may give you an aspect of price momentum you want for a particular market more than another indicator, so you use that one. When you are trading a different market, you may feel that RSI may do the job better and you use it.
How do you use momentum strategy?
There are different customized ways traders use the momentum strategy in their trading. However, the common momentum strategy signals are as follows:
- Crossing the centerline
- Overbought and oversold levels
- Momentum divergences
Crossing the centerline
All the indicators used for the momentum strategy have a center level, which may be marked with a line by default or not. The centerline can be the 50% level, as in the RSI and stochastic; the 0.0 level, as in the CCI and MACD; or the 100% level, as in the rate of change (aka the momentum indicator).
The indicator line or histogram crossing above the centerline and ascending is an indication of rising price momentum. On the other hand, the indicator line or histogram crossing below the center line and descending is an indication of a declining price momentum or increasing downward momentum.
Some of the momentum indicators, such as the RSI, stochastic, CCI, and Williams %R, have overbought and oversold levels marked on the indicator box. When the indicator line or histogram reaches the overbought level, it indicates that the buying momentum is extreme and will likely start declining, heralding a change in price direction. Thus, when the indicator line drops from the overbought level, traders see it as an indication of a potential price decline. The opposite is true when the indicator descends into the oversold level and rises from there.
Perhaps, the most reliable signal of a potential price reversal is the appearance of divergence, and all momentum indicators show that signal. A divergence occurs when the price swing and the indicator swing are out of sync. There are different types:
- Bullish regular divergence: It forms when the price swing is making a lower low while the oscillator is making a higher low. Being a bullish reversal signal, it is mostly seen after a prolonged downtrend or a multi-legged pullback in an uptrend.
- Bullish hidden divergence: It forms when the price is making a higher swing low while the oscillator is making a lower low. It indicates the end of a pullback in an uptrend.
- Bearish regular divergence: It forms when the price swing is making a higher high while the oscillator is making a lower high. Being a bearish reversal signal, it is mostly seen after a prolonged uptrend or a multi-legged pullback in a downtrend.
- Bearish hidden divergence: It forms when the price is making a lower swing high while the oscillator is making a higher high. It indicates the end of a pullback in a downtrend.
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