Traders in the stock market trade there for many smaller profit chunks but the assessment of the behaviour of the stocks is difficult because of the volatility of the market. So, a trader uses many tools in their trade to increase their chances of profit and momentum indicators are among them. A trader uses these to know the rate of change in the price of a stock.
Momentum indicators are not used standalone and used with other tools because these indicators are designed to tell the time period in which a change of price is happening but not the direction of movement i.e. trend.
What are Momentum Indicators
Momentum indicators are an important and widely popular tool in the technical analysis of stock and are used to determine the strength or weakness of a stock’s price. These indicators calculate the rate at which the stock price is rising or falling and indicate the momentum of the stock price movement. These are statistical figures that are calculated based on the price and volume data of stocks. Momentum indicator as a supporting tool with the Charts and moving averages gives you a complete picture of any stock.
Some momentum indicators indicate to you in advance the change in price movement that is going to occur and which are expected by the trading experts. Such momentum indicators telling the information in advance are called leading indicators. While there are some indicators, which indicate the predicted change in price movement at a later stage when the stock starts moving in that direction. Such indicators indicating to the trader at later stages are called lagging indicators.
Momentum Indicators are normally used with the moving average indicators to confirm the movement of price for a stock. When a stock price starts rising within a moving average, that means it is somewhat confirmed that it will continue to move as predicted.
Types of momentum indicators
Nowadays there are many indicators available for traders to ascertain the condition of the market at the stock exchange, but the Popular momentum indicators include moving average convergence divergence (MACD), and Relative Strength Index (RSI). We will discuss important momentum indicators in our subsequent articles.
The RSI indicator
The Relative Strength Index (RSI) indicator is widely used by traders and it measures the change in the price and the speed at which the price of the stock fluctuates. It is actually an oscillator which oscillates between the range of 0 to 100. It helps traders to identify the trend by indicating an overbought or oversold situation. Formulae used to calculate RSI are:
RSI = 100 – [100 / (1 + (Average of Upward Price Movement/ Average of Downward Price Movement))]
But don’t worry, you don’t have to get into all these mathematical details as the software will do this for you.
The Moving Average Convergence Divergence (MACD) indicator is also termed the best momentum indicator because of its certain advantages over other indicators. It also helps the trader to identify the trend by indicating an overbought and oversold condition. MACD indicators have two lines and no boundaries. If the MACD lies above zero means it is a Bullish trend and if it lies below zero means a Bearish trend. So it helps a trader to identify and trade in the trend.
MACD = 12 periods EMA – 26 periods EMAwhere EMA is the exponential moving average.
Use of momentum indicator for a trader
For a trader, momentum at a certain level is not ideal for the trade and he avoids it. But for the conformity of the situation, more than one indicator should be used at a time. Momentum indicators help the trader to identify the trend and accordingly he can enter or exit the trade. Also, it can give a signal of trend reversal when the momentum reaches a certain level.
Advantages of momentum indicator for a trader
Momentum indicators are widely used tools by traders because it shows the stock price’s movement over a period of time and how strong these movements are and will be. It shows this information regardless of the price movement i.e. whether the price is rising or falling.
Momentum indicators are useful for a trader because they help the trader to analyse the market and pinpoint the spot where the direction of movement or trend can be reversed. These points are found with the help of the divergence between momentum and price movement. So, we must know the concept of Divergence before reading about these indicators in depth.
What is Divergence
Divergence means the condition when the price of a stock is moving opposite to that of the indication of a technical indicator in that time frame. It is very useful for a trader because it alerts the trader about the weakening of the strength of price movement and can also be a signal of a trend reversal in the near future. Divergence can be found between any technical indicator movement and the price movement of the stock. Divergence is also of two types namely positive and negative divergence.
Disadvantages of momentum indicators
Nothing can be perfect, especially in this highly volatile market. The same is true for the momentum indicators as well. They have their own limitations which you as a trader must know:
Its Time Taking: Trading with a momentum indicator can be time taking because daily updates are necessary for you to know. You should keep tracking the momentum indicators on an hourly or daily basis.
Trend sensitive: It is generally expressed that these indicator works best when the market is in the Bull phase. In the Bear phase profit margin is reduced because of over-speculation sometimes.
Momentum indicators give helpful information to a trader when to enter into a trade. These indicators have an edge over other indicators because they pinpoint the time frame in which the change in price movement is taking place. But history and research show that momentum indicators are more useful in the Bullish phase i.e. when the price is rising as compared to the Bearish phase when Prices are thrashing.