Momentum Indicators in Trading
Let’s start by understanding momentum indicators. Momentum indicators are technical indicators that help analyse the strengths and weaknesses of stock price changes. Simply put, these indicators help determine the rate of stock price rise and fall in the market.
These momentum trading indicators are widely popular amongst traders and investors as they have shown reliable results in the past.
Many rely on a mix of momentum indicators and other technical indicators to pinpoint the exact time frame under which the stock price tends to change.
Formula & Components of Momentum Indicators
The introduction of online trading portals has made analysing the market easier but understanding the calculation process can help make better decisions.
Calculating momentum indicator is primarily done to get the value of momentum in price change.
Here’s how you can calculate the volume of momentum indicators:
MOM = (current closing price ÷ closing price of a previous period) x 100.
Under the momentum indicator formula you have to just divide the current closing price with the last closing price and multiply the number with 100 to get the value.
The Role of Divergence in Momentum Indicators
An aspect of momentum indicators that is crucial to analyse is divergence. Divergence or momentum divergence is said to have occurred when the price and volume of a security start to move in different directions. This phenomenon usually occurs when the price of the security is increasing but the trading volume is decreasing, also reflecting the lack of investors' interest in the security.
Many call this divergence a disagreement between the indicator and price. Now, analysing divergence becomes important because it indicates a potential for trend reversal simply because the growth in market price is based on weak factors. Keeping an eye on momentum divergence can help you make better decisions about your money.
Types of Momentum Indicators
Now that you have a fundamental understanding of momentum indicators, let’s understand the different types of momentum indicators:
Momentum indicators are primarily used for the purpose of understanding the momentum of price change. Now, with relative strength Index is a type of momentum indicator that helps understand the pace and magnitude at which the price is changing. This helps evaluate whether securities are underpriced or overpriced.
Understanding market trends is a key factor in making the right investment choice. Average directional Index helps in understanding the market trend and market direction. This type of momentum indicator is used to detect whether the market is ranging or trading and then structure a trading strategy.
Moving average is a common technical analysis tool that is used to detect and measure trend momentum. Moving average convergence divergence reflects the relation between two moving averages of a security’s price.
Did You Know? MACD was developed by Gerald Appel in the 1970s.
Stochastic oscillators work on a simple principle of market trend. If there is an upward trend, the closing price of a security will be closest to the recent highest closing price and if there is a downward trend in the market then the closing price will be closest to the recent lowest closing price.
Did You Know? Investors rely on a combination of Stochastic Oscillators, Moving Average Convergence Divergence (MACD) and Relative Strength Index (RSI) to predict market trends with more accuracy.
ROC is an unbounded momentum indicator that calculates the percentage change in price between the current period and any given time frame of the past. Remember that the ROC indicator operated against zero. If the price changes go upside it is a positive price change indicator and vice versa if the price changes move downward. ROC indicator is also used by many to pinpoint market divergence as this helps determine a possibility for price change trend.
Pros & Cons of Using Momentum Indicators
Before you decide to rely on momentum indicators, evaluating both pros and cons is crucial.
Pros of Momentum Indicators
Relying on momentum indicators help in analysing market trends by providing details into market divergence, direction in which the market is moving etc. For example ADX is a reliable tool to understand whether the market is trading or raging.
Momentum indicators can be used to determine the entry and exit points in the market. Relative strength Index helps understand whether the security is underpriced or overpriced. Similarly, rate of change can be used to pinpoint a positive or negative price change in the market.
One of the biggest advantages of momentum indicators is that it helps evaluate whether the strength and weakness of price changes of a security. For instance: Momentum divergence can be used to detect whether the price change levels are based on strong or weak factors.
Cons of Momentum Indicators
Since momentum indicators are completely based on evaluating the momentum in price changes, there are times when a sudden price change gets indicated as a negative signal leading to flawed signals on the chart.
Another limitation of momentum indicators is that the data they provide is prone to becoming outdated quickly. This happens because of constant trend reversals and absence of price direction in the market.
Momentum indicators do not provide comprehensive analysis of the market thus making them not reliable in isolation. Investors often mix momentum indicators with other technical indicators to get accurate results.
Risks Associated with Momentum Indicators
Momentum indicators are reliable in many ways especially when it comes to analysing the speed and magnitude of price change. However, there are certain risks associated with them that must be kept in mind:
Investors who rely solely on momentum indicators are at risk of market reversals. Know that market trends are not permanent and they will change. Investment decisions based on recent price changes with an anticipation of continuation in the change can be detrimental. It is important to remember that past performance is not a guarantee for future outcomes.
A common risk associated with momentum indicators is that they can be considered reliable only in terms of short-term investment goals since the primary focus is on following trends. Constant selling and buying of securities can be risky for investment in securities that are meant to generate profit in the long-run.
Momentum indicators provide data based on changes in the security price. Since the market is volatile, it can induce frequent buying and selling of securities that require constant market gauging and add unnecessary stress.
A risk that is associated gravely with momentum indicators is that it can induce the tendency to focus on trending stocks which might not be the best approach in the long run.Traders indulging in momentum trading often tend to pursue trending stocks or stocks that have showcased a recent positive price change thus restricting themselves from diversification and leveraging the market.
Conclusion
Learning how to smartly use momentum indicators can work as a reliable trading strategy. However, it is crucial that you carefully understand both sides of relying on momentum indicators to make a smart decision. Additionally, choosing a credible trading platform helps you get access to multiple tools for technical analysis so that you do not have to manually analyse the market every time you decide to make a move.
Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.
This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.
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