Want to master the art of momentum trading? Look no further. In this FXOpen guide, we’ll explore how to use momentum indicators, the signals they generate, and five of the best momentum indicators for trading.
What Is a Momentum Indicator?
Momentum indicators are technical analysis tools that help traders gauge the force behind and direction of trends. These indicators can show traders optimal entry and exit points and provide valuable insight into whether a trend is likely to continue or reverse.
While there are many ways to represent momentum in technical analysis, all momentum indicators analyse an asset’s price movement and the speed of that movement. They are called momentum indicators because they measure the force behind price moves, similar to how we calculate speed and momentum in physics.
Types of Momentum Indicators
Momentum indicators can be categorised into three main types based on the price movements they focus on.
Closing Price Compared to the Previous Close
Indicators in this category compare the closing price of an asset to its previous closing price, which can help traders identify markets that are potentially overbought or oversold. These types of leading momentum indicators can be beneficial for short-term trading strategies since they can pinpoint areas that may lead to quick reversals. Examples here include the relative strength index (RSI) and Momentum.
Closing Price Compared to Range
This type of indicator compares an asset’s current price action to how it behaved over a specified period, typically accounting for highs, lows, opens, and closes. This period could be a set number of candles or a single candle. These indicators gauge market strength and can help traders identify potential reversals, trends, and breakouts. Examples are the average directional index (ADX) and the commodity channel index (CCI).
Closing Price Compared to Moving Average
Lastly, these indicators can show traders how fast or slow price action is moving relative to its moving average(s). Because they rely on moving averages, these indicators are considered lagging and often used to confirm trends and reversals. One of the most notable examples is the moving average convergence divergence (MACD) indicator.
The Significance of Momentum Technical Indicators
Momentum indicators play a crucial role in providing insights into the strength, direction, and potential reversal points of market trends. They’re able to quantify and represent hidden clues about the future market direction in an easily interpretable way. By learning how to read momentum indicators, traders can develop more effective trading strategies, identify potential profit opportunities, and manage risk more efficiently.
Momentum indicators produce a range of signals that offer traders an edge over the markets. Let’s take a look at some of the most common momentum signals.
Overbought and Oversold Signals
These signals indicate when an asset's price has moved too far in one direction and is likely to reverse. For example, RSI generates overbought signals when the reading rises above 70 and signals oversold conditions when the reading falls below 30.
Divergence signals occur when the price of an asset moves in the opposite direction of the momentum indicator, suggesting that the current trend may be weakening. For instance, when the price is making higher highs, but RSI is making lower highs, this indicates a bearish divergence that increases the likelihood of a downward move.
These signals are generated when the indicator's lines cross each other or cross a certain threshold. A common example is in the MACD, where traders look for crossovers between the fast MACD line and the slower signal line to spot potential entry and exit points.
Top Five List of Momentum Indicators for Technical Analysis
Now that we understand the types of signals that momentum indicators produce, let’s break down five of the most popular indicators. If you’d like to experiment with them yourself, you’ll find each indicator waiting for you in the free TickTrader platform.
Relative Strength Index (RSI)
The RSI is one of the most popular and well-documented momentum indicators. It measures the speed and change of price movements by comparing the average gain to the average loss over a specified period, usually 14.
RSI is an oscillator, moving between 0 and 100. Values above 70 are considered overbought, while values below 30 indicate oversold conditions. When the RSI moves out of overbought or oversold territory, many traders interpret this as a reversal confirmation. Sustained movements above or below the midpoint (50) can also be used to confirm a bullish or bearish trend, respectively. Moreover, traders look for divergence between the RSI and price to identify weakening trends and possible reversals.
Average Directional Index (ADX)
The ADX is a momentum indicator used to determine a trend’s strength. Unlike most other momentum indicators, its reading doesn’t move according to the direction of price action, i.e. it doesn’t move up if bullish or down when bearish. Instead, it ranges from 0 to 100, with values above 25 indicating a strong trend and below 20 suggesting a weak or non-trending market.
The formula for ADX is relatively complicated, taking an average of the negative directional indicator (-DI) and positive directional indicator (+DI). These lines compare the current highs and lows to the previous highs and lows, smoothed and divided by the average true range (ATR).
ADX is commonly used in combination with other indicators, as it simply confirms the trendiness of a market. For example, traders might use a leading indicator like RSI to anticipate bullishness and confirm the trend when ADX crosses over 25.
Commodity Channel Index (CCI)
he CCI is a versatile momentum indicator that measures an asset's price deviation from its average price, relative to its mean deviation. It uses a constant in its calculation to ensure that 75% of values fall between +/- 100, with moves outside of the range generally indicating a trend breakout or continuation. It can also show extreme overbought or oversold conditions when its value exceeds +/- 200.
The CCI requires a more nuanced approach than other indicators and is typically used as a tool to confirm a trader’s directional bias and to identify potential ‘buy the dip’ opportunities. For instance, a visually identifiable bullish trend can be confirmed by looking at the CCI. If its value is skewed toward 100+, traders can be confident in their observation. When the market cools off, CCI will fall below 100. Traders can then confirm a pullback entry with a move back into the +/- 100 range.
Moving Average Convergence Divergence (MACD)
The MACD is a highly regarded trend-following momentum indicator that shows the relationship between two moving averages of an asset's price. It subtracts a longer exponential moving average (EMA) – usually 26 periods – from a shorter EMA – typically 12 periods – to produce the MACD line. It then uses a 9-period EMA of the MACD line to plot the signal line. MACD also commonly features a histogram that shows the distance between the MACD and signal lines.
Traders use crossovers between the MACD and signal lines as potential entry and exit signals. Additionally, when the MACD histogram crosses above or below the zero line, it can indicate bullish or bearish momentum in the market. Lastly, it’s also possible to spot divergences between price and the indicator’s peaks and troughs, similar to how divergences are identified with RSI.
The Momentum indicator is a simple yet effective tool that measures the rate of change in an asset's price over a specific period. It compares the current closing price to the closing price a specified period ago (usually 14 or 30). The value of the Momentum depends on the market it’s applied to. For example, using the Momentum indicator in stocks will result in a fluctuating value typically between +/- 20, depending on the stock’s price. For forex pairs, its range may look more like +/- 0.02.
The common feature across all markets, however, is the zero line. Generally speaking, positive Momentum values indicate upward price movement, while negative values suggest downward movement. It can also show overbought and oversold conditions, but its lack of defined boundaries means this can be tricky. However, Momentum is especially useful for identifying divergences.
Things to Consider When Trading Momentum Indicators
While momentum indicators can be an effective addition to any trader’s arsenal, there are a few things to be aware of that can increase your chances of success.
Trade with the Trend: Trends often last longer than you may think, and constantly looking for trend reversals will only end in frustration. Look for bullish signals during an uptrend and bearish signals in a downtrend.
Use Multiple Indicators: Relying on a single indicator can lead to false signals. Many traders find success by combining a lagging indicator, like MACD, with a leading indicator, like RSI. Combining two or three indicators can help confirm signals and improve your accuracy.
Beware of False Signals: Momentum indicators can sometimes generate false signals, especially in sideways or choppy markets. Being patient and waiting for an ideal setup before entering a trade is vital.
Relying Too Heavily on Indicators: While momentum indicators can be helpful, relying solely on them without considering price action, market structure, or other technical aspects can lead to poor trading decisions. Use these indicators alongside other tools for a higher probability momentum indicator strategy.
Now that you have a comprehensive overview of momentum indicators and the signals they produce, it’s time to put your knowledge into practice. After experimenting with a few indicators and settling on your favourites, you can open an FXOpen account. You’ll be able to trade over 600+ markets with low costs and ultra-fast execution speeds while partnering with one of the world’s fastest-growing forex brokers. Good luck!
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