Last Updated on 12 June, 2021 by Samuelsson
Momentum is one of the common terms you would often come across in technical analysis because it tells you about the strength or weakness of the trend. As a trader, you need to find ways to effectively measure the strength of an asset’s price, and momentum indicators can help you in that regard. So, what are the common momentum indicators?
Momentum indicators are technical analysis indicators a trader can use to determine the strength or weakness of the price movement. The common ones include the rate of change (also known as the momentum indicator among Forex traders), relative strength index (RSI), stochastic, Williams %R, commodity channel index (CCI), and moving average convergence divergence (MACD). Though they all use different formulas, they generally tell the trader how the price has progressed over time.
To make it easier for you, we will discuss the topic under the following headings:
- What are momentum indicators?
- How momentum indicators work: Is momentum a leading indicator?
- What are the types of momentum indicators?
- Common types of momentum indicators
- Trading with the momentum indicator strategy: How to trade with momentum indicators
- Pros and cons of using momentum indicators in trading
- Momentum indicators vs. price action: Which is better?
- Tips for using momentum indicators in your trading
What are momentum indicators?
In trying to understand momentum indicators, the first thing is to ask: what is momentum? The term is borrowed from Newton’s first law of motion, which indicates that a body in motion doesn’t change momentum unless acted upon by an external form. So, the term can be said to indicate the manner of movement of an object. In the context of financial markets, the term momentum is used to describe the rate at which the price of an asset moves in a particular direction.
Momentum indicators, therefore, are those technical analysis indicators a trader can use to determine the strength or weakness of the price movement. The common ones include the rate of change (also known as the momentum indicator among Forex traders), relative strength index (RSI), stochastic, Williams %R, commodity channel index (CCI), and moving average convergence divergence (MACD).
Though they all use different formulas, they generally tell the trader how the price has progressed over time. These indicators identify when the price is moving either upward or downward and how strongly. For optimal performance of momentum indicators, it is best to combine them with other indicators.
How momentum indicators work: Is momentum a leading indicator?
As we stated earlier, the concept of momentum is used to describe how the price moves. Momentum indicators show you how fast the price is moving and when the speed is diminishing, which can be a prelude to a possible change in direction.
Generally, the momentum indicators work by comparing where the current price to a certain reference point over a specified period, but different indicators use different formulas and calculations to achieve that. Some momentum indicators, such as the RSI, also compares the number of up bars and down bars over a given period.
Whatever the case, the number of periods used in the comparison is up to the trader or analyst to decide. But what determines increasing or decreasing momentum is majorly the position of the price in relation to where it was in the past. 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.
You may ask: Is momentum a leading indicator? Interestingly, yes! Momentum is a leading indicator, so it can foretell potential changes in the price action even before they occur. They work by measuring the rate of change or the speed of movement of the price, so they can tell when the price is no longer progressing in a particular direction as it used to.
Since momentum indicator is a leading indicator, a declining momentum is often a pointer to the fact that the market is becoming exhausted and a retracement or reversal is imminent. Simultaneously, an accelerating momentum condition indicates that the prevailing trend is strong and would likely continue to form a breakout in most cases.
It is also important to note that most momentum indicators are referred to as the oscillators because they oscillate around a centerline, which can be 0.0%, 50%, or 100% point and may or may not be displayed on the indicator settings on your trading platform.
Common types of momentum indicators
There is a long list of momentum indicators in forex trading. However, we would only be looking at the common momentum indicators — MACD, RSI, stochastic, CCI, and internal bar strength (IBS) — in this article.
We all know the MACD as a technical analysis tool that measures the relationship between the difference between two exponential moving averages and a simple moving average of that difference. The indicator consists of the MACD line, which can be represented as a histogram, and the signal line. But you may be wondering: Is MACD a momentum indicator?
Well, it is. While it can be used to show the trend, it is also used to indicate the momentum of the trend. In fact, the MACD is considered a trend-following momentum indicator. The indicator’s formula and calculation are as follows:
MACD Line = 12-Period EMA − 26-Period EMA
Signal line = 9-Period SMA of MACD line
From the formula above, it can be deduced that the MACD is obtained by subtracting the 26-period exponential moving average (EMA) from the 12-period EMA and then getting a 9-period SMA of the difference.
From the MT4 chart above, you can see that the MACD line is represented as a blue histogram while the signal line is represented as a dotted red line. These two lines (MACD line and signal line) are the basic parameters you need to interpret the MACD as a momentum indicator: The MACD crosses above the signal line indicates a rising momentum, and when it crosses the 0.0 level, it shows an even greater upward momentum. Conversely, when the MACD crosses below the signal line, it shows a declining momentum, and crossing below the 0.0 level shows even greater downward momentum.
Sometimes, the difference between the MACD Line and Signal Line is plotted as a separate histogram called the OsMA. It is often a separate indicator in most trading platforms, but in TradingView, it is the histogram plotted alongside the MACD Line and the Signal Line.
Relative Strength Index:
Introduced by J. Welles Wilder, the Relative Strength Index (RSI) is a momentum indicator used in technical analysis to measure the strength of price movement. The RSI is an oscillator with readings from 0 to 100. Generally, readings of 30 or lower indicate oversold market conditions and a potential upward reversal, indicating an opportunity to buy. In contrast, readings of 70 or higher indicate overbought conditions and an increase in the possibility of price weakening (going down) which is an opportunity to sell.
The RSI can be calculated using the formula below:
RSI = 100 – [100 / (1 + (Average of Upward Price Change / Average of Downward Price Change) ) ].
The RSI has a simple and well-detailed interpretation by traders: whenever the RSI crosses above the horizontal 30 reference level, it is a bullish signal, whereas when it crosses below the horizontal 70 reference level, it is a bearish sign. To make it clearer, we can say that RSI values of 70 or above indicate that a financial asset is becoming overbought or overvalued and may be heading for a trend reversal or corrective price pullback. An RSI reading of 30 or below indicates an oversold or undervalued condition.
Another scenario may also occur with the RSI in a trending market; it may fall into a band or range: hitting only the 70 and 100 levels in an uptrend and the 30 and 0 levels in a downtrend. It would be easier to determine the strength of the trend during this range and look out for any potential reversals in trend. You can combine the RSI with trend lines or moving averages to achieve this with ease.
Stochastic is a momentum indicator that was developed in the 1950s by George C. Lane. A stochastic oscillator is a momentum indicator that calculates whether the price of an asset is overbought or oversold compared to price movement over a specified period. Stochastic does not measure price or volume; instead, it compares the most recent closing price to the range for a given period. The standard period is 14 days, though this can be adjusted to meet specific analytical needs.
The formula for calculating stochastic is given below:
Stochastic = (low of the period – current closing price)/(total range for the period) * 100.
For instance, if the 14-day high is 150, the low is 125, and the current close is 145, then the reading for the current session would be (145-125)/(150-125)*100, or 80. By comparing the current price to the range over time, the stochastic oscillator shows how consistent the price is at closing near its recent high or low.
As can be seen above, the stochastic moves between 0 and 100. The area above 80 is designated as overbought, while the area below 20 is taken as oversold. So, when the indicator rises above 80, the market is considered overpriced. Conversely, when the indicator falls into the oversold region, the market seems underpriced. However, these are not always indicative of impending reversal; very strong trends can maintain overbought or oversold conditions for an extended period.
A more potent indication of a potential price reversal is the divergence signal, which occurs when the price swings and the indicator movement are not in sync. Depending on the nature of the price swings and the ensuing signals, there can be four types of divergences:
- Bullish regular divergence: This type of divergence occurs when the price swing is making a lower low while the oscillator is making a higher low. It mostly forms after a prolonged downtrend or a multi-legged pullback in an uptrend, and it is a bullish reversal signal
- Bullish hidden divergence: A hidden divergence occurs when the price is making a higher swing low while the oscillator is making a lower low. It is seen mostly when there is a pullback in an uptrend, and it gives a bullish signal, marking the likely end of the pullback and a continuation of the uptrend.
- Bearish regular divergence: This type of divergence occurs when the price is making a higher swing high while the indicator is making a lower high. It occurs mostly when the price has been in an uptrend for a long time, and it gives a bearish reversal signal.
- Bearish hidden divergence: This type of hidden divergence occurs when the price is making a lower high while the oscillator is making a higher high. It is seen mostly when there is a pullback (a price rally) in a downtrend; it gives a bearish signal, marking the potential end of the pullback and a continuation of the downtrend.
The Commodity Channel Index, CCI for short, is a technical indicator that measures the current price level with an average price level over a given time. Donald Lambert launched it in 1980 to identify cycles in commodities. As a momentum indicator, the CCI shows the overbought and oversold levels.
It is an unbounded oscillator that generally fluctuates between +100 and -100. Traders use the CCI in a variety of ways: retracements, breakouts, and divergent trades.
The CCI can be calculated using the formula below:
CCI = (TPt – TPAVGt) / (.015 * MDT)
- CCI is the Commodity Channel Index for the current period.
- TPt is the typical price for the current period, t.
- TPAVGt is the moving average of the typical price.
- 0.015 is a constant.
- MDT is the mean deviation for this period.
The major applications of the CCI momentum indicator are for spotting new trends, watching for overbought and oversold levels, and indicating weaknesses in trends when the indicator diverges with the price. Traders can interpret the CCI in the following ways:
- When the CCI moves from negative or near-zero territory to above 100, it shows that the price is about to begin a new uptrend, thus presenting a buying opportunity.
- A movement from the positive or near-zero readings to below -100 shows that a downtrend is about to begin, which is a good time to go short. Overbought or oversold levels are not fixed since the indicator is unbound. Therefore, traders look to past readings on the indicator to get a sense of where the price is reversed. For one stock, it may tend to reverse near +200 and -150. Another commodity, meanwhile, may tend to reverse near +325 and -350.
- Divergence: this occurs when the price swings and the CCI movement are not in sync. For instance, if the price is making a higher high when the CCI is making a lower high, it could signal that the trend is becoming weak.
Internal Bar Strength (IBS):
The Internal Bar Strength (IBS) momentum indicator is a technical tool that was designed by Volker Knapp. It is represented as a line that oscillates between 0 and 100.
The formula for calculating the internal bar strength is given below:
IBS = (Close – Low) / (High – Low)
The default period for the IBS indicator is five bars, but you can set whatever you prefer. Traders often use the IBS for scalping, day trading, and swing trading purposes. They normally set the levels 20 and 80 as oversold and overbought levels, so when the indicator crosses those levels, they will be expecting a price reversal.
Trading with the momentum indicator strategy: How to trade with momentum indicators
Traders can use the momentum indicator to know overbought and oversold conditions and the strength of prevailing trends. Overbought means that the price is somehow overvalued, while oversold implies that the price is undervalued. In addition to the overbought/oversold conditions, which may signal a potential reversal, momentum indicators also give divergence signals, which are even a stronger indication of a potential reversal.
There are many ways to use momentum indicators in trading. These are some of them:
Identifying an emerging trend: When the indicator line crosses the centerline, which may be 0.0, 50, or 100 level, depending on the indicator, it shows that the price is starting to gain momentum, which might signal the emergence of a new trend if it coincides with a breakout price action. A rise above the centerline indicates a positive momentum, while a fall below it shows a negative momentum.
Monitoring price swings: Swing traders may wish to momentum indicators to filter swing signals within the current trend. In a simple trend, the swings of the indicators between oversold and overbought levels often correspond with the price swings. So, the indicator line rising from the oversold level might be an indication to buy. On the other hand, the indicator line dropping from the overbought level might be a signal to sell.
Spotting the end of a pullback: The momentum indicator can be used to know the end of a pullback using overbought, oversold signals, and divergences. A bullish divergence can be an indication to go long, while a bearish divergence can be an indication to go short.
Trade Trigger: The momentum indicator can be used as a trade trigger. In this case, you should add a moving average line to your indicator. You may buy when the momentum indicator crosses above the moving average from below and sell when the momentum indicator crosses below the moving average.
Pros and cons of using momentum indicators in trading
There are several advantages that the momentum indicator gives a trader, and they include the following:
- Momentum indicators help traders to determine the strength of price movements, irrespective of the direction of the movement — whether upward or downward.
- They help traders and market analysts to detect points where the market is likely to reverse — for example, the divergence between momentum and price movement helps traders detect potential reversal points.
- Although the momentum indicators do not show the direction of price movement, they can be combined with other technical indicators such as moving averages and trend lines, which show price trends and directions.
Despite being an invaluable tool in trading, the momentum indicator has its downsides:
- It has little or no information to give the trader apart from what is obtainable from mere looking at the price chart. For instance, if the price is going down aggressively, it would be evident both on the price chart and the momentum indicator.
- Being a leading indicator, it often gives false signals.
Momentum indicators vs. price action: Which is better?
The answer is not straightforward. It depends on the trader. Some traders prefer to trade raw price action, while others prefer to use indicators, including momentum indicators. However, because it is easier to learn how to trade with indicators than with price action, most newbie traders often prefer to use momentum indicators to identify their trade signals.
Experienced traders who learn the various price action patterns, including chart patterns and candlestick patterns, tend to prefer price action signals to momentum signals. Some also like to combine both indicators and price action. Whatever the case, it is better to learn all of them and also know how to spot support and resistance levels.
Tips for using momentum indicators in your trading
- Avoid following the exact indicator settings of other traders because all markets are not the same — find out the best setting for the market you are trading.
- Do not make the mistake of having multiple trading indicators from the same category because they are correlated and often give the same signals — for example, using RSI and stochastic
- Every trading indicator on your charts must have a purpose, whether it’s defining the trend, identifying the area of value, trail your stop loss, etc. — Remove whatever does not add any new value so that your chart doesn’t get messy.
- Use momentum indicators to confirm price action and not to generate trade signals on their own — they are better off as a trade trigger when a trade setup has formed at the right level in the right trend.