Momentum Indicator

Article byJyotsna Suthar
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Momentum Indicator?

A momentum indicator is a technical analysis tool that measures the strength and direction of a stock’s price trend. It is used to identify the strength and stability of a stock during market volatility and to help determine whether the stock is likely to continue moving in its current direction.

momentum indicator

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The momentum indicator strategy compares a stock’s current price to its price in the recent past to determine the rate of price change. This information can help traders identify sensitive points in a stock’s price and make informed trading decisions. However, the momentum indicator can be subject to distortions, such as irregular stock price fluctuations. Therefore, it should be used with other technical analysis tools for a more comprehensive assessment.

Key Takeaways

  • A momentum indicator is a technical tool used by stock traders to measure the rate of change in stock price and determine the trend’s strength.
  • American mechanical engineer Welles Wilder explained the momentum concept in his 1978 book “New Concepts In Technical Trading Systems.”
  • The types of momentum indicators include the Relative Strength Index (RSI), Moving Average Convergence Divergence (MACD), Stochastic Oscillator, True Strength Index (TSI), and Rate of Change (ROC).
  • Momentum is not just calculated by subtracting the previous day’s closing price from today’s, but various formulas and algorithms are used to calculate momentum in different indicators.

Momentum Indicator Strategy Explained

The momentum indicator measures the rate at which a stock’s price changes, allowing for the determination of its relative strength through fluctuations in the market. The indicator also assesses a stock‘s sensitivity to market movements. Welles Wilder introduced the concept in the late 1970s, but there is a specific method for utilizing the indicator effectively.

The origin of the momentum concept dates back to the late 20th century. In 1978, American mechanical engineer John Welles Wilder Jr introduced the momentum indicator strategy. The concept is related to acceleration and deceleration, where a news pump (accelerates) and the stock moves in a certain direction, either upward or downward. The momentum indicator measures the rate at which the stock will follow a certain price trend.

The term “momentum” refers to the velocity (or the speed) of a particular price trend in a stock price. So, during market hours, if the stock price falls or rises, this indicator calculates the momentum or the rate at which it moves. Traders also use this indicator to determine overbought and oversold levels during a time frame. The stock’s momentum can be affected by excessive trading. Additionally, the momentum indicator can be a useful tool for identifying changes in divergence.

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Formula 

The momentum indicator is calculated as the difference between the latest closing price (C) and the closing price “n” days ago (Cn) or as the ratio of the latest closing price (C) to the closing price “n” days ago (Cn) multiplied by 100.

Momentum (M) = C – Cn

Or 

Momentum indicator (M) = (C/Cn) * 100

C is the latest closing price of a particular stock.  

Cn was the closing stock price “n” days ago. 

Types

There are several types of momentum indicators trading strategy used in technical analysis, including:

  • Relative Strength Index (RSI): RSI is a popular momentum indicator that measures the speed and change of price movements. It is used to help identify whether a stock is overbought or oversold. The default look-back period for the RSI calculation is typically 14 days, and the indicator ranges from 0 to 100. A value above 70 is typically considered overbought, while a value below 30 is considered oversold. 
  • Moving Average Convergence Divergence (MACD): MACD (Moving Average Convergence Divergence) is an important momentum indicator used to understand trend continuation in stock prices. The MACD is calculated using two exponential moving averages (EMAs) with 12 and 26 days periods. The MACD line is obtained by subtracting the shorter EMA from the longer EMA. If the MACD line and the signal line (a 9-day EMA of the MACD line) converge or meet at a point, it suggests that the trend will continue. However, if there is a divergence between the two lines, it can indicate a potential trend reversal.
  • Stochastic Oscillator: It compares the closing price of an asset to its price range over a specified period. The result is between 0 and 100, where values above 80 indicate overbought conditions, and values below 20 indicate oversold conditions. Traders use the Stochastic Oscillator as a momentum indicator to determine the potential trend reversal points and confirm trend strength.
  • True Strength Index (TSI): It is a momentum indicator that helps to identify price trends and overbought/oversold conditions in a financial asset. It measures the rate of change of a fast and slow-moving price average to determine trend strength and potential trend changes. TSI values oscillate between positive and negative values, and readings above or below specific thresholds can signal bullish or bearish momentum. 
  • Rate of Change (ROC): It measures the percentage change between the current price and the price n-time periods ago. It is used to identify whether a stock is overbought or oversold by comparing its current price to its historical prices. ROC can be a useful tool for traders to determine a stock’s trend and make informed trading decisions.

Each of these indicators measures momentum in a slightly different way. Still, they all aim to provide traders with a visual representation of the speed and direction of price movement for a particular stock or security.

How To Use?

Let us look at the steps on how to use momentum indicators in stock trading:

  • Selection Of The Stock And Indicator: Individuals can select their favorite stock before proceeding. Also, choose any two indicators mentioned above. The most popular among all are RSI and MACD.
  • Plot Entry And Exit Points: Once decided on the indicators, keep entry and exit points for each indicator. For example, by using 14-day RSI, plot the entry-exit points.
  • Determine The Trend: Many traders use momentum indicators in certain strategies to track the trend of stocks. It includes 100 line crosses, crossover, divergence, and others. 100 line cross is a strategy where a trader will buy a stock (turn bullish) when the level crosses 100. The crossover strategy indicates buying or selling when the indicator surpasses or falls below the moving average. The perfect example includes a MACD indicator.
  • Trade The Stock: After analyzing and tracking the trend, look at the profits and trade the stock in the current session.

Examples

Let us look at the examples of momentum indicators for a better understanding:

Example #1

Suman has been a stock trader for the past three years, and today she wants to determine the momentum of her favorite stock, Tesla. Due to recent events such as the acquisition of Twitter, she is unsure of the stock’s trend. Therefore, she uses the Moving Average Convergence-Divergence (MACD) indicator to predict the trend. Suman plots the MACD entry-exit points over 12 days, connect the points and draws a trend line. She also uses the Relative Strength Index (RSI) indicator to support her analysis further. Based on her analysis, Suman estimates the future trend of the Tesla stock and makes a trade decision.

Example #2

According to an analysis report by NASDAQ, published on November 15, 2022 — at 07:00 pm EST, Donaldson Co. Inc. (DCI) had a market cap of $7B and closed 1.2% below its 52-week high of $61.12. The stock has been up 3.0% year-to-date, down 1.3% over the past 12 months, and up 40.7% over the past five years.

In the 2nd half of November 2022, the trading volume was 22.5% higher than the 20-day average, and its beta was 0.9. The RSI of the stock was between 30 and 70, and MACD indicated an upward trend. However, the stock closed below its Bollinger band, indicating it may be oversold. DCI’s share price performance compared to the S&P 500, Dow Jones, and its peers in the Materials sector varies on a 1-year and 5-year basis, with a higher price-to-earnings ratio than the average peer.

Frequently Asked Questions (FAQs)

What are the advantages of the momentum indicator?

Momentum indicators have several advantages in stock trading. Firstly, they help traders identify trends in the stock market and can be used as a confirmation tool with other indicators or analysis techniques, providing traders with additional information to support their decisions. Finally, they can help traders avoid potential stock market traps by alerting them to divergences and other warning signs. 

What are the disadvantages of the momentum indicator?

The momentum indicator has limitations such as false signals, late entries or exits, potential divergences, and lag due to past prices. It also doesn’t account for underlying factors driving market movements. Therefore, momentum indicators should be combined with other analysis tools to have a more comprehensive understanding.

Which is the best momentum indicator?

There is no universally agreed-upon best momentum indicator. The choice of the best momentum indicator will depend on individual trading styles, market conditions, and specific traded assets. Some popular momentum indicators include Relative Strength Index (RSI), Moving Average Convergence-Divergence (MACD), and Stochastic.

This has been a guide to what is Momentum Indicator. We explain the concept in detail with how to use it, examples, formula, and types. You can learn more about it from the following articles –