Momentum indicators or MOM indicators are widely popular technical analysis tools used by traders to measure the rate at which the price of a stock fluctuates. They complement other indicators really well as they only pinpoint a time period in which the change in market price is taking place. Research indicates that these tools have been more useful when the market is on the rise rather than when it’s going down.
In this article
- Momentum Indicator Formula
- What is Divergence?
- Types of Momentum Indicators
- Advantages of Momentum Indicators
- Limitations of Momentum Indicators
- Momentum Indicator – FAQs
Momentum Indicator Formula
Traders and analysts do not need to calculate momentum manually. It can be measured using various investing software programs and websites. But it’s essential for all market participants to follow the entire calculation process to know about variables that are utilised to ascertain the trend and momentum of a financial instrument.
The value of momentum indicators can be calculated by following these two simple steps –
- Divide the current closing price by the price of a previous period
- Multiply the quotient by 100
Hence, the formula for MOM indicators is given by,
MOM = (current closing price ÷ closing price of a previous period) x 100
What is Divergence?
A divergence arises when a momentum indicator is continuously falling with the market price of a stock, but then rotates in an upward direction and stops following a downward movement of the market price. This signifies that the indicator has stopped tracking the market price movement of a stock. It is a clear signal that the momentum of the market price movement is decreasing.
Usually, divergence is an indication that the momentum of the market price movement is stalling or is going to reverse. If movements of the market price and the momentum diverge with each other in an upward manner, it is known as a bullish divergence. And, when both of these suddenly turn downwards after moving in an upward direction, it is known as a bearish divergence.
Types of Momentum Indicators
Traders can use various types of MOM indicators to their advantage. Some of them are discussed in the momentum indicators list given below –
Relative Strength Index (RSI)
RSI is one of the most popular MOM indicators among traders. It is an oscillator that measures price changes and also the rate at which such changes are taking place. This indicator swings back and forth between 0 and 100. Market participants can spot signals by observing the divergences and inefficient swings.
RSI is also useful in identifying if there’s an uptrend or downtrend. If RSI shows signs of overbuying, it generally indicates that it’s the right time to sell and make a profit. Likewise, when RSI shows signs of overselling, it is an indication that it’s the right time to buy.
Moving Average Convergence Divergence (MACD)
Often regarded as the best momentum indicator, MACD is a trend-following indicator. It represents the relationship between 2 moving averages of a financial instrument’s price. MACD moves back and forth between moving averages and indicates momentum. Usually, MACD is calculated by subtracting the 26-day EMA from the 12-day EMA. After this calculation, a 9-day EMA of the MACD, also known as “signal line” is plotted on a graph along with the MACD line. It acts as an indication to all traders whether to buy or sell.
Average Directional Index (ADX)
ADX is one of the most used momentum indicators. Its primary function is to identify the strength of a trend. Both uptrends and downtrends can be represented by the Positive Directional Indicator (+DI) and the Negative Directional Indicator (-NDI). Thus, ADX usually consists of 2 individual lines, which give an indication to the traders whether to go long or short.
Rate of Change (ROC)
ROC is a widely used momentum oscillator that moves below and above zero. It compares current prices with prices of a previous period. When the ROC moves upward, it indicates a significant rise in price, whereas a downward movement depicts a sharp fall in price.
This momentum-based tool is used by traders and investors to compare the current closing price of a financial instrument over a specific period of time. Stochastic oscillator tracks the momentum and speed of the market and does not consider volume and price. It is used by many participants to forecast market price movements.
Advantages of Momentum Indicators
Firstly, MOM indicators represent the change in the price of a financial instrument over a period of time. It also helps to measure the strengths or weaknesses associated with such movements.
Secondly, momentum indicators also help the market participants to undertake trading decisions by providing signals which can be identified through the divergence caused by the change in price.
Finally, these indicators help to measure the strength of price level changes but do not consider the trajectory of such price movements. Hence, MOM indicators are used alongside other technical analysis tools like moving averages, which can identify trends and price trajectories.
Limitations of Momentum Indicators
- MOM does not move back and forth between the predetermined limits. Hence, the overbought and oversold levels need to be restored for every stock individually. momentum indicators.
- If market prices at the start of an indicator window are too high or too low, it causes distortion.
- Movements are usually inconsistent and thus unpredictable.
Momentum indicators are crucial tools for all market participants. But it is essential to note that they should be used with other technical indicators that help in identifying trends.
Momentum Indicator – FAQs
Ques. How to use momentum indicator?
Ans. When the momentum indicator’s first version is a positive number, the price is above the price “n” periods ago. When it’s negative, the price is below the price “n” periods ago. If the momentum indicator’s second version is a percentage above 100, the price is above the price “n” periods ago.
Ques. How to use the intraday momentum indicator?
Ans. One can choose 1-2 indicators to keep a track of all the entries and exits. RSI can be used in segregating the trend and entry points. The RSI must be more than 70 on rallies during uptrends above 30 on bearish trends.
MACD can be used in determining when to exit. For example, MACD can be used in tracking stock loss in trading trends. If the trend seems to be going up, you can consider exiting when the price falls beneath the line.
You can also follow other indicators and combine them the same way as explained above for intra-day trading using momentum indicators.
Ques. What is a momentum strategy?
Ans. Momentum investing requires a strategy to capitalize on the flow of an existing market trend. The strategy includes being invested in the respective stocks for the long haul, futures or market ETFs showing an upward trend and short the respective assets having downward-trending prices.
Ques. What is the definition of momentum effect?
Ans. The momentum effect can be defined as the usual market phenomenon in which asset prices follow a trend for a long time. This can reflect the economic evolutions, but at times, it might bring in a growing discrepancy between prices and “fundamental” values.