What are Momentum Indicators? How do they Help Traders?
While long-term investors rely primarily on fundamental analysis, day traders rely on what is called technical analysis to make their trading decisions. Technical analysis is a kind of security analysis that uses past price and volume data to predict future prices.
There exists a particularly important class of technical analysis tools called ‘momentum indicators’. In technical analysis, ‘momentum’ is a measure of the speed of price movements, i.e. the rate of price change. As the name suggests, momentum indicators are tools that can help traders determine the momentum of a given security, so that they can decide whether to take a position or not.
There are several different momentum indicators, each with their own rationale, formula, and level of reliability. Let’s explore these indicators in more detail.
What are Momentum Indicators?
Momentum indicators are tools that traders can use to determine the strength of an uptrend or downtrend in price action. Typically, such indicators do not provide any information about the direction of price movement; as a result, they are best used in conjunction with other tools and indicators.
In addition, momentum indicators can also help traders identify that an ongoing trend has begun running out of steam, and that the direction of price movement is about to reverse. Such a reversal is often a good point in time for traders to enter the market.
Also Read: Parabolic SAR Explained
Types of Momentum Indicators
There are several different types of momentum indicators. Each of them has its own characteristics and uses. Some of them may be considered to be more reliable than others.
Before discussing specific momentum indicators, it is important to discuss two broad classes of such indicators:
- Leading Indicators: Such indicators are considered to indicate impending changes in price action. Effectively, what this means is that such indicators can be thought of as having some amount of predictive power, and can be used to identify market entry and exit opportunities.
- Lagging Indicators: As the name suggests, such indicators follow price trends rather than predicting them. They are usually used by traders to confirm price trends before they take market positions.
Let’s now look at some of the most important momentum indicators:
1. Relative Strength Index (RSI)
The RSI effectively takes a security’s daily gains and daily losses over a given period of time (typically 14 days), averages them out, and then compares them. It is represented by a line graph that can vary in height between 0 and 100.
The RSI can be useful for recognising when a security may be on the verge of a trend reversal or a correction (or “retracement”), as well as when a security may be overbought or oversold.
A security is said to be overbought when its price level is higher than its “true” or “intrinsic” value (however that may be determined). Similarly, an oversold security is one whose price level is lower than its true value. Such securities often undergo price corrections, which is why keeping an eye on them is useful for traders.
An RSI value of less than 30 usually indicates that the corresponding security is oversold, while an RSI value of more than 70 indicates that it is overbought.
2. Moving Average Convergence/Divergence (MACD)
To understand the MACD, we first need to understand what an exponential moving average (EMA) is. A moving average is simply an average that constantly changes on the basis of new incoming data points. The moving average of the price of a security is often used to smooth out the effects of brief, random fluctuations over a given period of time. An exponential moving average (EMA) is a moving average in which recent data points are assigned higher weightage than older data points.
Let’s now talk about the MACD indicator. This indicator reflects the relationship between two different EMAs of a given security’s price. In particular, the value of the MACD at a given point in time is obtained by deducting the 26-period EMA from the 12-period EMA.
The ever-changing MACD value traces out a line called the MACD line. Now, the 9-day EMA of the MACD value is plotted and overlain over the MACD line; this new line is called the signal line. The relationships between these two lines are what serve as various kinds of signals for traders.
For instance, the MACD line crossing the signal line from below is a buy signal, and vice versa. Moreover, the speed with which such a crossover happens indicates the extent to which the relevant security is overbought or oversold.
3. Squeeze Momentum Indicator
This indicator is used to identify periods of increasing or decreasing volatility. In other words, it can be used to get some idea about when a market might enter a trend after flat-lining for some time, or vice versa. Market breakouts after flat periods often result in strong directional movement; as a result, such breakouts are often attractive to traders.
The workings of this indicator are quite technical, and involve two other kinds of technical analysis tools called Bollinger Bands and the Keltner Channel.
4. Average Directional Index (ADX)
This indicator can be used to determine the strength and direction of a trend. This indicator consists of a main trendline and two additional positive and negative directional indicators (+DI and -DI).
An ADX value of above 25 indicates a strong trend, while a value of below 20 indicates a weak trend. Various kinds of crossovers of the -DI and +DI lines are taken to represent trading signals.
Also Read: Swing Trading – Strategies, Setups, List & Pros and Cons
Momentum Indicator Formula
It might be a good idea to know exactly how some of the momentum indicators discussed above are calculated. But before we look at that, we should look at the formula for the most basic momentum indicator of all: the momentum itself. While the momentum can also be used as an indicator in principle, it rarely is in practice.
The formula for the momentum indicator is, very simply:
Momentum = (Closetoday) – (CloseN days ago)
This yields the momentum over the previous N days.
How to Calculate Momentum Indicators?
We can now get some idea of how some of the momentum indicators discussed above are actually calculated. We will restrict ourselves to the RSI and MACD, as the calculations of the other two indicators are overly technical.
1. RSI
RSI = 100 − (100 / (1 + RS)),
where RS = Average of x days’ up closes / Average of x days’ down closes
2. MACD
MACD = 12-period EMA − 26-period EMA,
Here, EMA = [Vt × (s / (1 + d))] + EMAp × [1 − (s / (1 + d))],
where Vt = value today, EMAp = EMA on the previous day, s = [2 / (selected time period + 1)], d = number of days
Also Read: What is Money Flow Index (MFI) and How to Use it in Trading?
How to use Momentum Indicators for Intraday Trading?
There are two frequently encountered maxims in trading: “The trend is your friend” and “Let your winners run.” The point of both of these is that market trends are often quite persistent, and that it can make a lot of sense to get on a trend and ride it for as long as possible.
The concept of momentum discussed here is simply a more formal way of looking at the same idea. Thus, the point of momentum indicators is to highlight the formation, persistence, or reversal of trends, so that traders can plan their next move wisely.
Typically, in the context of intraday trading, the time frames used with such indicators are on the shorter side, and range from 1 minute to 1 hour. In certain situations and markets, traders might also keep an eye on prior days.
Moreover, it should be noted that the indicators discussed above mainly provide useful insights in three particular situations:
- When they are at an extreme: such a situation typically indicates that the security in question is overbought or oversold
- When a momentum indicator and the actual price diverge in different directions: such a situation can indicate an imminent change in the direction of price movement
- When a momentum indicator crosses its mid-line (or zero line): such a situation often signals that the price is about to change direction
Thus, by keeping an eye out for such situations, traders can get useful signals for their decision-making process.
The Best Momentum Indicators in Technical Analysis
It is effectively impossible to evaluate momentum indicators in any objective way. All of them can be useful in a variety of situations, and all of them can serve to reinforce each other as well as other kinds of indicators. Moreover, each of them has its own set of signals and degree of reliability.
Nevertheless, we can say that the RSI and MACD are very frequently used by day traders, and are among the most popular and important momentum indicators.
Advantages of Momentum Indicators
- They can be used to predict the price movements of securities.
- They allow traders to confirm trends and trend reversals.
- They can indicate a situation where a security is overbought or oversold.
- They can provide traders with market entry and exit signals.
- They can help corroborate each other and additional kinds of indicators as well.
Disadvantages of Momentum Indicators
- Some momentum indicators may not indicate the direction of the trend
- Most such indicators are lagging indicators, thus minimising their predictive power
- Like most indicators, momentum indicators can also be subject to varying interpretations in many cases
Final Word
Momentum indicators are undoubtedly one of the most important parts of any modern trader’s arsenal. While there are many momentum-based indicators in use, the list of momentum indicators provided above should be sufficient for the needs of beginner traders.
FAQs
Ans. Momentum indicators are a class of technical analysis tools that are used to determine the magnitude of the momentum of a security’s price, and sometimes the direction of the price trend as well.
Ans. The Relative Strength Index (RSI) is a type of momentum indicator that is useful for identifying potential reversals in price trends.
Ans. The Moving Average Convergence/Divergence (MACD) is a type of momentum indicator that can provide traders with buy or sell signals, and can also indicate a situation where a security is overbought or oversold.
Ans. The squeeze momentum indicator is a type of momentum indicator that is mainly used to determine whether the volatility of the price movements of a security is high or low.
Ans. The Average Directional Index (ADX) is a type of momentum indicator that can be used to determine the strength as well as direction of a price trend.
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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
