Momentum indicators are technical tools used by traders and are part of technical analysis. Traders use it to identify the speed or the rate that the price of security changes. Note that these tools cannot be used to identify the direction of a price but only the time frame in which the price is happening.
Divergence is most of the time an indication of the current price trend – due to the signal that momentum is holding back – and is likely coming to an end or reverse.
When price movement and momentum diverge in an upward trend it is a bullish divergence. On the other hand, if the price movement and momentum continually go upwards and the momentum indicator suddenly turns downwards, it will be a bearish divergence.
According to analysts, a momentum strategy is a powerful tool because based on the natural law of motion. That law was defined by Newton, and it says that a body that is in motion tends to be in that motion until some force acts on it. Thus, a particular trend in the market tends to stay in the given movement. Not to change it, of course, until market factors reverse the given motion.
There are a few momentum indicators that traders can use. However, we took the most popular and widely used by traders. In the next segment, we will cover the different Momentum indicators a trader can use, but it is important to mention a Momentum indicator as a stand-alone indicator that exists and can be added to the chart. These are the following:
MACD is one of the most popular momentum indicators. It works by using two indicators – moving averages – turning them into an oscillator by subtracting the largest average from the shortest average. In other words, MACD indicates momentum as it oscillates between moving averages as they happen, overlap, converge, and move away from one another.
As mentioned above the indicator uses two moving averages. This is up to the traders’ and analysts’ discretion but usually, it uses a 12-day and 26-day exponential moving averages (EMA)*, subtracting the 26-day one out of the 12-day. The MACD line is basically the result we get after doing so. It usually showed in a graph with a 9-day EMA acting as a signal line that can identify price movement turns.
From this chart, we can see that the share price has a corresponding trend and in correlation with the momentum moving.
If it happens, for example, that the bullish momentum is in question, then the momentum line is positive. But it is not moving as a high trend, there is a probability that the share price will fall, and the trend will become negative, below the zero lines.
It means that there has been a desynchronization between momentum and stock prices. In that case, the momentum indicator separated from the price movement, malware happened. Then you need to adjust either the share price or the momentum.
Lastly, the most important part of the MACD is the histogram. The histogram reveals the difference between the MACD line and the 9-day (EMA). For instance, when the histogram is positive but the line begins to fall downwards it signals a weakening trend. On the other hand, when the histogram indicates a negative line that is moving upwards, it signals that the downward trend is weakening.
*Note: EMA is similar to simple moving average (SMA) both measuring a trend line over the period of time. The SMA is calculating the average on data prices whereas the EMA applies more weight to data that is more recent and thus more accurate.
The RSI is also a very popular momentum indicator. It is also an oscillator that acts as a metric for price changes and how fast they change. The indicator is moving between zero and 100. Analysts and traders can spot signals if they look for divergence, failed swings of the oscillator, and when the indicator crosses over the centerline.
Any RSI trends above 50 indicate a positive signal, if the RSI is 70 or above is often an indication for overbought values of securities. For example, Tesla stock has an RSI of 77. This shows how overvalued the stock is. Moreover, if the RSI goes below 50 shows a negative downtrend movement. If RSI is below 30 it indicates possible oversold conditions.
Lastly, the ADX is one of the most popular momentum indicators. It is used to both to measure the direction of the price and the momentum. Welles Wilder established the Directional Movement System – consisting of the ADX, the Minus Directional Indicator (-DI), and the Plus Directional Indicator (+DI) to be able to identify both factors together.
The ADX is derived from the smoothed averages of the -DI and +DI, which are themselves derived from the comparison of two consecutive lows and their respective highs. The index is the portion of the Directional Movement System that acts as a metric for the strength of a trend, regardless of its direction. It’s important to note that with the ADX, values of 20 or higher suggest the presence of a trend. For any reading lower than 20, the market is viewed as “directionless.”
It is best to use these indicators along with other tools since they cannot identify the direction that the price movement will go. The use of momentum indicators requires some technical analysis. Momentum is a good friend of the trader and always behind the trend.
As such, it is always used in combination with other indicators and knowledge of basic market movements. Technical analysis, as in the case of using momentum indicators, requires signs of confirmation from various parties that the decision on trade is correct, that it will make a profit.
