If you use technical analysis tools for your trading, then you need to make sure that you are using at least one good Momentum Indicator. Momentum indicators help us to measure and know the strength of an upward push, or the weakness of a downward push.
What is a Momentum Indicator?
A momentum indicator is a tool used for technical analysis on trading charts by traders. The indicator’s objective is to identify the trends and better understand the fluctuation in speed and rate of change in financial instruments. These financial instruments include stocks, options, futures, currencies, etc.
The indicators can also be categorized based on their power to identify trends. The two types of indicators are:
1. Leading Indicators
In this type of indicator, the indicator gives the trader information about what is likely the future direction of the market or instrument being traded.
2. Lagging Indicators
Instead of foretelling a trend reversal, lagging indicators follow a trend. Since lagging indicators react afterward, they perform best when price changes last a considerable time. They thereby validate price movements, allowing you to make the appropriate longer term investments. Lagging indicators are not considered sufficient tools for trading intraday as most decisions need to be made quickly with current information.
How to Calculate Using Momentum Indicator?
John J. Murphy’s book “Technical Analysis of the Financial Markets” explains how to use momentum indicators to calculate a stock’s momentum. Below is the momentum indicator formula
1. Start with taking the difference between the current closing price and the closing price’ n’ days ago. As
Momentum = Current Closing Price – Closing Price ‘n’ days ago
2. After calculating with the above formula, you can know that if the momentum value is positive, the stock is trending upwards and plotting above the zero line.
3. Conversely, a negative momentum value, which indicates the stock is trending downward, is plotted below the zero line.
By plotting this momentum against the zero line with the momentum indicator formula, traders and analysts can easily identify the strength and weaknesses of the trends in stock.
Different Types of Momentum Indicators
Every indicator has its strengths. There are several types of momentum indicators that can be used to make your day trading more successful! These indicators are used to identify when an asset is becoming overbought (overvalued) or oversold (undervalued), which helps to understand the strength or weaknesses of a trend!
1. Relative Strength Index (RSI)
Relative Strength Index (RSI) is one of the best momentum indicators for day trading used in technical analysis to assess overbought or oversold circumstances in the price of an asset. It measures the speed and magnitude of security’s recent price fluctuations. The RSI can range from 0 to 100 and is represented visually as an oscillator, a line graph oscillating between two extremes.
The RSI is calculated as,
● RSI = 100 – (100 / (1 + (Average of Upward Price Change / Average of Downward Price Change)))
● The Average of Upward Price Change is calculated by taking the sum of all upward price changes over the preceding 14 days and dividing by 14.
● The Average Downward Price Change is calculated by taking the sum of all downward price changes over the preceding 14 days and dividing by 14.
An RSI number below 30 indicates that a stock is oversold, while an RSI above 70 indicates that it is overbought.
2. Moving Average Convergence Divergence (MACD)
It is a trend-following and powerful indicator considered by traders that hovers around zero. MACD helps measure both important factors, the trend and momentum. This tool uses two moving averages and generates relevant results for better analysis.
● The MACD is calculated by subtracting the 26-day exponential moving average (EMA) from the 12-day EMA. The signal line is then created by applying a 9-day EMA to the MACD line.
● Traders look for points where the MACD line crosses the signal line, indicating a possible trend change.
It can also be used to identify both aspects of overbought/oversold conditions and divergences in the market. These divergences, or discrepancies can provide early warning signals of potential reversals.
3. Rate of Change (ROC)
The ROC indicator is another best momentum indicator that measures the percentage change in a security’s price over a specific period. The increase or decrease in the closing price of a security is compared to the closing price of a security in the previous time period.
It is calculated as:
● Subtracting the price ‘n’ periods from the current period price and dividing the result by the price ‘n’ periods ago.
● The result is multiplied by 100 to convert it into a percent.
And hence the result is used to identify overbought and oversold conditions and to monitor the speed of price movements.
4. Stochastic Oscillator
This indicator measures the speed and direction of the price movements. This indicator assumes that prices tend to close near the extreme highs or lows of the recent trading range.
It gives an estimate to the traders of the security’s price and its relation to the current price range; if the reading is above 80, the condition can be considered overbought. And if the readings are below 20, the condition will be considered oversold. The price moves in its range, and the oscillator oscillates between 0 to 100.
How to Use Momentum Indicators: A Quick Guide!
To use momentum indicators precisely, follow the below steps.
1. Identify a momentum indicator that suits your trading style and goals. You can use momentum indicators like the Relative Strength Index (RSI), Stochastic Oscillator, Rate of Change (ROC), Momentum, and Moving Average Convergence Divergence (MACD).
2. Once the indicator is decided, start by inputting the entry and exit values.
3. Use the momentum indicator per the formula to determine the current trend. A reading above 70 indicates the asset is overbought, while a reading below 30 indicates the asset is oversold.
4. Monitor the momentum indicator and utilize it for further entry and exits.
5. You can also use other technical indicators with the momentum indicator to confirm trades and decide accordingly.
Momentum Indicator Example For Easy-Learning
Paul has been a commodities trader for the past five years, and today he wants to determine the momentum of his favorite commodity, Gold. Due to recent events such as the US-China trade war, he is still determining the commodity’s trend. Therefore, he uses the Moving Average Convergence-Divergence indicator to predict the trend. Paul plots the entry-exit points over 9 days, connects the points, and draws a trend line. He also uses the Relative Strength Index (RSI) indicator to support his analysis further. After using indicators and analysis, he will estimate the future trend of the Gold commodity and make a trade decision.
Frequently Asked Questions about Momentum Indicators
Q.1 What are the advantages of the momentum indicator?
Momentum indicators are helpful as they provide traders with a quick and easy way to measure the strength of a trend and identify potential entry and exit points. Also, the momentum indicator provides additional information to support trading decisions, so you are aware of the traps!
Q.2 What are the disadvantages of the momentum indicator?
There are several limitations, such as its vulnerability to large price spikes, false signals, late entry or exit, potential divergence, and others. Therefore, you must use it with other tools.
Momentum Indicators: A Tool for Analyzing Price Movement and Identifying Trading Opportunities
We can conclude that day trading is all about momentum! When used correctly with the help of effective learning, the momentum indicators can help you identify the opportunities so you can become a successful day trader!
For more information on Momentum and the technical indicators used with it to create a full trading system, go to https://www.theintentionaltrader.com/.