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Understanding Momentum Indicators

A momentum indicator is a tool that helps investors determine the strength or the weakness of their stock price. The formula compares a previous closing price with the most recent closing price and is an important concept in technical analysis. By using divergence, the momentum indicator can help you spot subtle shifts in your stock and decide whether buying or selling would offer more benefit.

It’s important to know the strategies for trading using the momentum indicator, how to use it when combined with other techniques, and how to calculate it. Learn how to properly use the momentum indicator and discover how it can help you build a stronger investment portfolio when combined with other trading strategies.

Key Takeaways

  • The momentum indicator is a technical analysis tool that’s used to determine the strengths and weaknesses of a stock or portfolio.
  • The momentum indicator measures the rise and fall of stock prices using indicators including the RSI and MACD.
  • A momentum indicator will help traders confirm the validity of their stock and gain a better understanding of when the best time to enter or exit a position is.
  • There are three popular momentum indicators:
    • Relative strength index
    • Moving average convergence divergence
    • Average directional index

What Exactly Is a Momentum Indicator?

The momentum indicator is a technical analysis tool that measures the rise and fall of stock prices using indicators including the relative strength index (RSI) and moving average convergence/divergence (MACD).

RSI is a form of momentum indicator that will help to evaluate overbought or oversold conditions in stock price or other assets by measuring the magnitude of recent price changes. The MACD strategy collects data from moving averages to help traders identify possible opportunities.

Divergence can warn of both positive and negative changes. It can warn of current price weakening, and in some cases, it will warn if prices are heading in the other direction. A positive divergence indicates the price of an asset is moving higher. A negative divergence indicates that the price of an asset is lowering.

A momentum indicator in trading will help traders to confirm the validity of their stock and trades based on price actions. Price actions are movements of the price of security plotted over time. They form the basis for the technical analysis of stocks and other commodities. While a momentum indicator does not supply you with a definite answer, it can supply you with a good idea of which direction your investments are heading.

Image via Flickr by investmentzen

Advantages of Using a Momentum Indicator

Momentum indicators show the movement of price, including how strong movements will be and whether they’ll go up or down. This tool is especially useful as a tool for traders to help them spot points where their stocks are growing and when the market will drop. You get a better understanding of the health of your selected stock, which will allow you to know the best time to enter or exit a position.

Another advantage of using a momentum indicator is that you can potentially discover when you’ll get the quickest returns. Basically, you’re looking to ride it out until the momentum has gone down so you generate a higher return.

Once you master this skill, your portfolio offers higher returns, while you gain knowledge of how to better invest in the future.

Popular Momentum Indicators

There are several options when it comes to choosing a momentum indicator. Traders utilize the following quite often.

  • MACD: As mentioned above, MACD is a great tool and one of the most popular momentum indicators. It uses two moving averages as indicators by converting them into an oscillator. It does this by using the longer average and taking it out of the shorter average. This means that the MACD will indicate momentum while oscillating between moving averages.
  • RSI: The relative strength index also works as an oscillator and will give you information on the price changes and the speed that they are changing. This indicator will fluctuate back and forth between zero and 100 with any RSI above 50 signaling a positive momentum, anything above 70 often indicating overbought conditions, below 50 indicating a downtrend, and under 30 often indicating oversold conditions.
  • Average Directional Index (ADX): This method was created by Welles Wilder as part of the Directional Movement System and includes the ADX, the plus direction indicator, and the minus directional indicator. This group was intended to help measure the momentum and direction of price changes.

Calculating Momentum Indicators

How do you calculate these popular momentum indicators? Knowing how to properly calculate them will help you determine the health of your stock and gain a confirmation of price action in trading.

  • MACD: The MACD uses two moving averages. Typically these consist of the 12-day and the 26-day averages, subtracting the 26-day from the 12-day. This results in the MACD-line which may then be graphed with a nine-day exponential moving average (EMA) and can be used to identify movement turns. When the histogram shows a positive, it indicates a weakening uptrend. When the histogram shows a negative, it indicates a weakening downtrend.
  • RSI: The formula for the relative strength index is calculated with a two-part formula. The RSI is equal to 100 – 100 / (1 + (the average of the upward price change divided by the average of the downward price change). In an uptrend (bull) market, the RSI tends to stay within the 40-90 range. In a downtrend (bear) market, the RSI tends to remain within the 10-60 range.
  • ADX: The average directional index is derived from the averages of the positive direction indicator and the negative direction indicator. These are derived by comparing two consecutive lows and two of the respective highs. A value of 20 or more suggests a trend while anything under 20 is viewed as being “directionless”.

The momentum indicator will come in useful as a means of confirmation. One of the better methods for use is looking for divergence between momentum and price to measure the strength behind a move, chart, selling, or staying.

Trading Using a Momentum Indicator

T here are a few trading strategies that are used with the momentum system. These strategies include combining a zig-zag pattern, divergence setup, and momentum indicator. The zig-zag pattern consists of three waves that investors hope allows them to enter at the break of the trend line.

  • Wave A is the initial wave.
  • Wave B is the second leg that must retrace less than 100% of wave A.
  • Wave C goes the same direction as Wave A but must extend beyond it.

If there is a divergence between the momentum indicator and the price, then a trade is set up.

Another strategy is support and resistance, where the areas of support are likely to stall, or resistance, where areas are likely to find supply are examined. When a support level breaks, it turns into a new resistance, and when a resistance level breaks, it turns into support. When examined and combined with a momentum indicator, investors can potentially be clued in on a bear type trade setup.

Knowing how to use a momentum indicator, combined with determination and diligence, can help you increase the performance of your investments. Keep in mind that while the chart is important, you also need to understand the overall health of the company. This will require reading financials and learning what they mean.

After you have calculated the momentum indicator, you need to continue to monitor your positions and pay attention to any stalling. If you can stay ahead of the game, you’ve mastered a skill that will be useful for your future investments. You can bring this skill into other aspects of trading to fully utilize your new knowledge.

Using a momentum indicator is worth the time and effort it takes to master it, but it isn’t for everyone. It can add diversity and accent your current investment portfolio as well as help generate a return in a less volatile market.