What are momentum indicators and what do they show?

Momentum indicators help traders get a more complete story of what price movement really means. When looking at a price chart, price action tells a trader what is happening. Momentum helps them understand why it is happening. This is particularly true when an asset is trading in a tight range. Ultimately profitable traders are looking to spot trends, and more significantly, trend reversals. Momentum indicators can help define clear lines of support and resistance that make it easier to see when price action may signaling that a reversal is about to occur.

Momentum indicators are ideal tools for finding crossover and divergence points. A crossover point is when data points for an oscillator (e.g. moving averages) cross over each other. A divergence is when the price action of an asset is moving in the opposite direction of the indicator. Both crossovers and divergences, when combined with other data, can be powerful trading signals.

Most charting software programs will automatically make the calculation for different momentum indicators available to traders. While having a variety of data points available to them, using different momentum indicators can deliver contradictory trading signals. For this reason, it’s recommended that traders choose one or two momentum indicators that they feel comfortable with based on their risk tolerance.

Introduction

As part of technical analysis, many investors use indicators to help take a statistical, rather than subjective, approach to trading. Indicators allow investors to view the money flow, volatility, trends, and momentum associated with an asset. This allows them to confirm a chart pattern and/or give them a more reliable buy or sell signal.

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In this article, we’ll be taking a look at some of the most common momentum indicators and how they are used. We’ll review why momentum is important to successful trading, define what momentum indicators are and what they show, and then review some of the standard momentum oscillators that traders use. Keep in mind that for many investors these momentum indicators are used in tandem.

Understanding momentum oscillators

One of the most common types of momentum indicators are oscillators. There are a variety of momentum oscillators including moving average convergence/divergence (MACD), the Relative Strength Index (RSI), the stochastic oscillator, the Rate-of-Change (ROC), Money Flow Index (MFI), Ichimoku Cloud and Chaikin Money Flow. Understanding each of these oscillators in detail is beyond the scope of this article, but we will provide a brief overview of how each of these momentum oscillators is used.

• Moving Average Convergence/Divergence (MACD) - One of the most common technical analysis tools is the moving average. The moving average gives a more complete picture of how the closing price of an asset is moving over a period of time. For a simple moving average, the closing prices are added together and divided by the time period being used (10 for a 10-day moving average, 26 for a 26-day moving average, etc.). With an exponential moving average, the most recent closing prices receive a higher weighting because those prices are perceived to be more significant when looking to determine trends. The MACD is plotted on a price chart as a line that represents the difference between a short term moving average (the 12-day is the most common) and a longer-term moving average (the 26-day is the most common). In reality, traders can – and do - use whatever time period fits their trading strategy. This number (called the MACD number) is plotted against a centerline which indicates the point where the two moving averages are equal. When the MACD is positive it indicates positive, or upward, momentum. A negative MACD indicates negative, or downward, momentum. Traders look for areas where the two moving averages cross over. These crossover points indicate a change in price momentum and can be useful in setting up a trade. They will also look for areas of divergence. Divergence occurs when the MACD line forms a rising low when the price is showing a falling low (a bullish divergence) or when the MACD is showing a falling high when the price is showing a rising high (a bearish divergence).
  
  
• Relative Strength Index (RSI) – this is another widely used momentum indicator that helps to identify overbought and oversold assets. The RSI oscillator ranges between 0 and 100. A measurement over 70 is consistent with an overbought condition and can be a sell signal. Likewise, a measurement under 30 is consistent with an oversold condition and can be a buy signal. A standard RSI calculation is based on 14 consecutive data points. A larger or smaller amount of data can be used. Also, if investors are using charting apps or software such as Stock Tickerpicker, the parameters of the oscillator can be adjusted (an 80/20 range will be more definitive than 70/30). One of the limitations to the RSI momentum oscillator is that prices can stay in an overbought or oversold range for a long period of time. That is why a common RSI trading strategy is to use the RSI indicator along with the MACD to look for crossovers that are consistent with periods where the RSI is showing readings above 70 or below 30.
  
  
• Stochastic oscillator – a stochastic oscillator is a momentum indicator that compares a stock’s closing price to its range of prices during the time frame being measured. The premise behind stochastic oscillators is that closing prices will tend to reflect market trends. So if the market is trending positive, an individual stock will generally close near its daily high, and if the market is trending lower, a stock will close near its daily low. Like the RSI, the stochastic oscillator is range bound between 0 and 100 with 80 and 20 being the overbought and oversold triggers respectively. However, its sensitivity to market movements can be reduced by adjusting either the time period or by calculating a moving average of the result. Along with the actual value that is calculated by the oscillator, a typical stochastic oscillator will include a line that represents a three-day moving average of the oscillator. Anytime the two lines intersect may signal that a reversal is ready to occur.
  
  
• Rate-of-Change Oscillator (ROC)– the ROC measures the change in price from one period to the next as a percentage. The ROC calculation is a comparison between an asset’s current price and its price from “n” periods ago. The value is a line that oscillates above and below a zero line to indicate overbought or oversold conditions. Anytime the ROC remains positive, prices are increasing no matter if the percentage has gone down. Anytime the ROC is negative, prices are decreasing even if the percentage has gone up. When prices spike sharply, traders will notice an upward surge in the ROC. Likewise, when prices move sharply downward, the ROC will show a downward surge.

• Money Flow Index Oscillator– the Money Flow Index (MFI) is different from other oscillators because it combines both price and volume data. This has led some analysts to call the MFI the volume-weighted RSI. Like the RSI, the standard MFI calculation uses 14 data periods. The standard overbought/oversold parameters are 80 and 20 although the creators of the index.

• Gene Quong, and Avrum Soudack, recommend using 90 and 10. A divergence between the oscillator direction and the price is considered a significant indication of a trend reversal.

• Ichimoku Cloud– an Ichimoku Cloud combines a variety of technical indicators into a “cloud” of information that attempts to show support and resistance points. When an asset is trading in a tight range, the ability to identify support and resistance points is critical to successful trading. The calculations used in an Ichimoku Cloud are:
  Conversion line: 9-period high + 9-period low/2B. Baseline: 26-period average: 26-period high + 26-period low/2
  C. Leading Span A: Conversion Line + Base Line/2
  D. Leading Span B (52-period average): 52-period high + 52-period low/2
  E. Lagging closing price: Closing price plotted 26 periods in the past
  
  Each of these calculations, or lines, will form a “cloud” that is shaded green when the value of C is greater than the value of D and red when the value of D is greater than the value of C.
  
  
• Chaikin Money Flow (or Chaikin Oscillator)– the Chaikin oscillator is similar to the MACD in that the oscillator uses two exponential moving averages. The standard parameters for the Chaikin Oscillator are the 3-day EMA and the 10-day EMA. However, the Chaikin oscillator applies the convergence/divergence of moving averages to the accumulation-distribution line instead of the closing price. Any cross above the accumulation-distribution line is an indication of underlying buying activity which is typically a bullish signal.

The limitation to momentum indicators

Momentum indicators suggest what should happen with prices. But investor sentiment often creates emotional responses that can cause prices to move in irrational patterns. To help manage the effectiveness of momentum indicators, it can be helpful for traders to use a combination of technical analysis tools such as Bollinger bands and Fibonacci retracements for further confirmation of the information they are seeing on a price chart. Also, different oscillators can provide conflicting information. So while it is helpful to have a variety of momentum indicators, it is best for traders to find the one or two oscillators that work for them.

The final word on using momentum indicators for trading

Using momentum indicators to inform trading decisions is an ideal way to boost an investor’s risk-adjusted return. Momentum provides the why behind price movement. Because they help illustrate the commitment of buyers and sellers, a momentum indicator can help provide confirmation of the existence of a trend or that a trend is about to reverse by suggesting that an asset is overbought or oversold. Momentum indicators generally work best with assets that are trading in a tight range by helping to define levels of support and resistance. However, momentum indicators should not be considered stand-alone tools for technical analysis. One reason for this is that while pointing out an overbought or oversold condition suggests where prices should move, prices can stay in their current state for a significant amount of time. Using other technical analysis tools such as Bollinger bands and Fibonacci retracements can help provide further support for a trading strategy.