Last Updated on May 24, 2022 by Aradhana Gotur
The rate at which stock prices increase or decrease is referred to as momentum. Momentum is a significant measure of strength or weakness in the price of an asset. A momentum indicator leverages this valuable information and highlights trading opportunities for investors. Let’s learn more about it.
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What is a momentum indicator?
A momentum indicator is an indicator that compares past and present values of assets to illustrate trend direction and quantify the rate of price change. It’s one of the leading indicators for determining the pace of change in stock prices. They work effectively in combination with other indicators since they only specify the period during which the market price changes.
Ways of trading with momentum indicators
The momentum indicators are used to generate trade signals, but they are better utilised to verify the viability of transactions based on price actions like breakouts or pullbacks. Traders may use these indicators in a variety of ways, including:
Crossovers are points where a security’s price and a technical indicator intersect. It is used to predict price momentum and trends. In regards to momentum indicators, they give trade alerts crossing centre or other lines. For example, in MACD (Moving average convergence divergence), a purchasing signal is generated when the moving line crosses the signal line from above or below.
Concept of divergence
Divergence is when a security’s price moves away from a technical indicator. It is used to understand the price movement and market mood. For example, when the price drops low while the momentum indicator moves high, it is known as a bullish divergence. It means that while the price decreases, the selling velocity is lessening, and the trend may be changing to an uptrend. When the price achieves more significant highs while the momentum indicator falls, this is known as a negative divergence. This means that, while the price is growing, the purchasing impetus is waning, and the trend may be turning to the downside.
Types of momentum indicators
Moving average convergence divergence (MACD)
The MACD is one of the significantly utilised momentum indicators. The MACD turns two indicators moving averages into an oscillator by subtracting the longer average from the shorter average. The MACD commonly employs two moving averages. The indicator generally uses the 12-day and 26-day exponential moving averages as a signal line that can indicate price movement.
Relative strength index (RSI) and Stochastic RSI
RSI is a technical tool that helps in pointing out overbought and oversold levels for a particular stock. Stochastic RSI indicator, also an analytical tool, works on the principle that the closing price of a stock is correlated with its swings – upwards and downwards. For instance, if a stock closes at a high, it could be indicative of an upward trend and vice versa. Both these technical overlays can be excellent tools to understand not just the market sentiments but also entry/exit positions, momentum strength, and trend for a particular stock.
Average directional index (ADX)
One of the most often utilised momentum indicators is the ADX. Its primary purpose is to determine the intensity of a trend. ADX is generally made up of two separate lines: a positive directional indicator (+DI) and a negative directional indicator (-DI) that indicate whether traders should go long or short on a particular asset.
Rate of change (ROC)
The ROC oscillator, which travels below and above zero, is a frequently used momentum oscillator. It compares current prices to prior periods’ prices. When the ROC travels upward, it implies a significant price increase and vice versa.
Advantages of momentum indicators
- Momentum indicators depict price movement over time and the strength of such actions, irrespective of whether the price is moving up or down.
- Momentum indicators are critical since they assist traders and analysts in identifying areas when the market may or may not turn.
- The divergence between price movement and momentum is used to determine the spots.
- Because momentum indicators only reflect the relative intensity of price fluctuations and not their directionality, they are used along with other technical indicators that display price trends and directions, such as trend lines and moving averages.
For traders and analysts, technical analysis is paramount. One such technical tool is momentum indicators. As important as they are, they cannot be utilised alone. Momentum indicators are helpful as they identify the strength of price movement trends and signal when they are about to conclude.