Momentum means how strong the movement is.
Momentum is an important concept in trading.
What are momentum indicators?
Momentum indicators or MOM indicators are tools that measure momentum of securities. Momentum trading indicators are popular technical analysis tools that measure the rate at which the price of a security changes.
Momentum indicators are readily available on intraday trading software platforms.
These trading indicators are used with other indicators as they mainly help determine the time frame in which the price change occurs and not the direction.
Advantages of momentum indicators:
Momentum indicators show the change in the price of a stock over time and how strong the movement is and will be. They are particularly useful for traders to identify points when the price direction can reverse.
Given that momentum indicators only show strength of movement, they are used with indicators such as moving averages which show the direction of price movement.
Concept of divergence in trading
Divergence typically indicates that the momentum of the price movement will stop soon or is about to reverse.
It occurs when the stock price is moving downward continuously along with the momentum indicator, however, later, the momentum indicator stops following the downward price movement or turns upward.
Thus, it is essentially a divergence of the indicator from the actual price movement, showing that the momentum of the current price movement is dropping.
Popular momentum indicators
1. Relative Strength Index (RSI):
RSI is a popular momentum indicator in technical analysis that measures the magnitude or extent of recent fluctuations in the security’s price.
It evaluates whether the stock is overbought or oversold. Showed as a momentum oscillator, RSI can have values from 0 to 100.
Typically, RSI values over 70 indicate overvalued or overbought and below 30 indicate undervalued or oversold.
RSI can be calculated using a formula involving the use of 14-period data of average gain and loss. However, we can easily access this on a trading platform.
So, let’s dive straight away into how to use RSI for trading.
As you can see, in the Wipro chart above, RSI values crossing 70 may indicate that it is becoming overvalued and may generate a sell signal, indicating the possibility of a trend reversal soon.
An RSI of 30 or below indicates an undervalued condition and may indicate the start of uptrend soon.
If RSI remains in a range, it denotes a trend.
For example, between Oct 2020-Jan 2021, the stock was in a steady uptrend. An uptrend may also be indicated when the RSI remains above 40 and frequently hits 70 or above like between April-July 2021. The opposite is true for Jul-Oct 2019.
A bullish divergence occurs when the RSI is in the oversold region followed by a higher low that corresponds to lower lows in the price. This is when bullish momentum is indicated. Any break above the oversold region can be taken as a signal for taking a long position.
A bearish divergence is when the RSI generates an overbought signal followed by a lower high corresponding with higher highs on the price.
Limitations: True reversal signals are rare, and false signals could lead to false alarms. A false positive, for example, would be a bullish crossover followed by a sudden decline in a stock.
RSI is suitable in a market where the stock price is alternating between bullish and bearish movements.
2. Average Directional Index (ADX):
ADX indicates trend strength. It does not show the direction of the trend but only its strength. Hence, it would need to be used with another indicator.
The red line indicates ADX.
When the ADX rises above the threshold (generally 25), it means that the stock price trend is showing strength. Combined with an indicator like Moving Average, it can help general buy/sell signals.
For example, in the figure above, the price crosses the 50-SMA and ADX crosses 25, which generates a ‘buy’ signal.
On the other hand, a flattish ADX indicates a weak trend, i.e., the stock price moves in no particular direction or is range bound.
ADX is an excellent trading tool to use to identify strong trends for trend trading.
A common mistake traders make is considering a falling ADX line for a trend reversal. That’s not true! A declining ADX line generally implies that the trend strength is reducing and not reversing.
Moving Average Convergence Divergence (MACD) is a trend-following momentum indicator that shows the relationship between two moving averages of a stock’s price.
Primarily, the 26-period exponential moving average (EMA) is subtracted from the 12-period EMA to get the MACD line. The signal line is the 9-day EMA.
MACD is presented using a histogram that plots the difference between the MACD line and the signal line. When the MACD line is above the signal line, the histogram will be on the top of MACD’s baseline.
MACD can be used to identify points to enter or exit trades when they form divergences and crossovers.
You can check out an example of a MACD crossover from our previous blog
As mentioned earlier, you do not have to manually calculate these momentum indicators. You can get them easily on an algo trading platform.
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