Momentum indicators
Looking to get a better understanding of the best momentum indicators and how to use them in your trading strategy? Then you’ve come to the right place! In this article, we’ll explore what these tools are, how to set them up, and the best way of using them in technical analysis.
What are Momentum Indicators in trading?
Momentum indicators (also known as MOMs) are technical analysis tools used to best determine the momentum at which an asset's price rises or falls. This momentum indicates whether an asset's value is strong or weak, helping a trader decide whether to buy or sell a particular asset. As MOMs only track a specific period in which a price change occurs, most traders use them in conjunction with other momentum indicators.
"Momentum indicators are important tools for traders, helping to identify potential trends and reversals in the market and providing insight into when to enter and exit positions." - Peter Brandt, Market Analyst
Different Momentum Indicators serve different purposes in technical analysis. The Relative Strength Index (RSI) measures the momentum and extent of an asset's price change (the price's relative strength), the Moving Average Index identifies market trends, and the Stochastic Oscillator measures the speed and direction of asset price movements.
As a single Momentum Indicator cannot create the best picture of market conditions during technical analysis, it is generally advised that a trader uses multiple trading indicators together for a clearer picture that more closely resembles reality. For example, to accurately determine whether Tesla Inc (TSLA) stock should be bought or sold, a trader could use the MACD, CCI, and RSI indicators together.
If a trader were to do this on March the 30th 2023, they would learn that Tesla's MACD was 1.88. As the MACD was above zero, the reading suggested that the price of Tesla stock was generally rising. Similarly, Tesla's CCI was 85.5, suggesting that Tesla stocks were trading above their statistical average. However, as the CCI reading was below +100, it also indicated that Tesla stock was not trading above its value.
The trader could then confirm this reading by looking at Tesla's RSI of 55.8, which indicated that the relative strength of the asset price movement was in a neutral zone – neither above nor below its value, a sign of price stability. When taking all these factors into account, a trader could conclude that March the 30th 2023 was a good time to buy Tesla stock.
As timing is key when trading, knowing when to strike is one of the activity’s most important aspects. The information provided by a Momentum Indicator is a trader’s best chance at making the right move at the right time.
Types of Momentum Indicators
The relative strength index (RSI)
To best measure how likely an asset's price movement is to continue in its current direction (relative strength) and the price movement's momentum and size, traders use a Relative Strength Indicator. If an RSI generates a value below 30, the reading suggests that an asset is oversold and that its declining price may briefly recover in a bounce before continuing to decline. On the other hand, an RSI reading above 70 hints at an asset being overbought and an upcoming but temporary price drop.
RSIs are typically combined with other trading indicators and analysis tools like trend lines, support and resistance levels, and moving averages.
Relative strength indicator formula
The RSI can be calculated through the following formula:
RSI = 100 - [100/(1 + (Average of Upward Price Movements/Average of Downward Price Movements))]
The moving average index
In addition to the RSI, traders can use another technical analysis tool: the Moving Average Index. This tool clarifies the price data collected from a financial market by creating an average price that it constantly updates. To do this, a Moving Average Index calculates an asset's average price over a specific period, which a trader can use to understand price movements best, allowing them to make profitable trading decisions.
To pinpoint the best price at which an asset should be bought or sold, a trader can use a moving average index in conjunction with the Moving Average Convergence/Divergence (MACD), a trading indicator that analyses an asset's general price direction. This indicator is calculated by subtracting an asset's 26-period Exponential Moving Average (EMA) from its 12-period EMA. It is displayed as a line on a graph.
Stochastic oscillator
In addition to the Relative Strength Index and Moving Average Index, traders can also use the Stochastic Oscillator. This indicator compares an asset’s closing price to its price range over a specified time period.
Stochastic oscillator formula
The formula is:
%K = (Current Closing Price - Lowest Low of the Past n Periods) / (Highest High of the Past n Periods - Lowest Low of the Past n Periods).
How to set up a Momentum Indicator
Before using a Momentum Indicator, a trader must correctly configure the tool to ensure they receive accurate readings. Suppose a trader does not set up their preferred time frame, indicator type, and number of periods. In that case, they may be unable to discover potential reversals in asset prices due to inaccurate readings. Most importantly, traders must select the asset they want to trade and the time frame they want to analyse. The trader must then choose the momentum indicator best suited to measuring the metrics mentioned above.
Once this groundwork is sorted, a trader can safely begin setting up their Momentum Indicator's settings. These settings include the time period used to calculate the indicator, whether the trader sees the indicator as a line chart or a histogram, and the indicator's colours. Traders can also select whether they want their indicator to measure the momentum of an asset price change or to compare the momentum of an asset price change to another.
A trader can finally add a Momentum Indicator to their chart and begin using it after completing the set-up process.
How to use Momentum Indicators
There are several ways for traders to use the best Momentum Indicators. The best trading indicators can inform a trader whether an asset is overbought. Such assets are traded at a higher price than their actual value and can usually be identified through an RSI reading above 70. Similarly, if an asset’s RSI is below 30, it could mean that an asset price has fallen too quickly and might temporarily recover in a flash, making it an oversold asset.
Why Use Momentum Indicators in Trading?
Entry/Exit Points
Trades can find good entry and exit points for an asset.
Overbought/Oversold Status
Momentum Indicators help traders determine if an asset is Overbought/Oversold.
Movement Strength
The strength of an asset’s price movement can be identified with the help of a Momentum Indicator.
Sometimes, a Momentum Indicator’s direction may differ from an asset price’s actual movement. This difference helps a trader decide just how real an asset’s price change is. These differences mean that a price movement is weak and that it might change. For example, if an RSI predicts that an asset’s price will fall but it doesn’t, this could indicate that the current price movement is weak. An RSI reading above 30 means an upward price movement will likely continue. When a reading crosses 70, this could point towards a probable price decrease.
Pros of using Momentum Indicators strategy
Using these tools as part of a trading strategy is a popular choice, as they provide users with three major benefits during their technical analysis:
1.First, traders can pinpoint when an asset price is likely to move higher or lower than its usual range or when the price direction is about to change and head in the opposite direction.
2.Traders are also made aware of upcoming, temporary changes to asset prices and can use this information to their advantage by modifying their strategy to suit current conditions.
3.Most importantly, these indicators help traders recognize the general direction of an asset's price movement. This information lets traders know when to buy or sell an asset.
Cons of using Momentum Indicators strategy
Unfortunately, despite their advantages, even the best Momentum Indicators have several downsides when used in erratic markets with rapid and unpredictable price changes. These include:
1.Inaccurate readings - assets that experience sudden and significant price changes may receive a flawed signal.
2.Outdated data - These indicators can quickly become outdated due to price reversals and the absence of a general price direction. To avoid outdated signals, traders combine Momentum Indicators with other trading indicators.
3.If a trader places all their trust in an indicator's readings, they could buy or sell an asset too quickly or too late, potentially leading to losses.
Conclusion
Overall, Momentum Indicators are the best resource for anyone interested in trading, especially since momentum is essential to the entire trading experience. To ensure a profitable trade, traders must recognise the best time to buy or sell an asset. As they provide traders with promising signs and the closest approximations to an asset price's future development, these analytical tools are invaluable to all traders.
Nevertheless, despite their importance, these trading indicators also have their limitations. To avoid any losses that may arise from following signals unquestioningly, it is best advised that traders use Momentum Indicators in conjunction with other trading indicators.
Looking to get a better understanding of the best momentum indicators and how to use them in your trading strategy? Then you’ve come to the right place! In this article, we’ll explore what these tools are, how to set them up, and the best way of using them in technical analysis.
FAQs
The general direction of an asset price begins to slow down when the direction has already been declining for a large period of time or when no activity (no highs or lows) regarding the asset price direction is reported in the news, earnings reports, or market analysis. Furthermore, if no other economic indicators like consumer confidence and stock prices support the general direction of an asset price, a trend has likely lost momentum.
To read a Momentum Indicator, look for a sudden increase or decrease in the indicator's reading. When the indicator is rising, an asset's price is generally rising. If the indicator is falling, the asset price is decreasing. If an indicator is flat, the asset's price is fixed between a particular high and low point without making notable movements beyond this range.
The best Momentum Indicators offered by easyMarkets include:
- The Relative Strength Index (RSI).
- The Moving Average Index.
- The Stochastic Oscillator.
