This guide teaches traders about what a Momentum Indicator can do as a technical analysis tool.
We start by distinguishing between positive and negative Momentum Indicator signals.
Contents
Then you’ll learn about how to read buy, sell, exit, and divergence signals by using the momentum indicator.
What Is The Momentum Indicator?
The Momentum indicator compares where the current price is in relation to where the price was in the past.
As to how far in the past the price comparison is made, is up to the technical analysis trader.
The calculation of Momentum is quite simple (n is the number of periods the technical trader selects). The current price minus the price n-periods ago.
What Makes The Momentum Indicator Positive Or Negative?
Hence, if the current price is higher than the price in the past, then the Momentum indicator is positive.
In contrast, when the current price is lower than the price in the past, then the Momentum indicator is negative.
Potential buy or shortsell entries are shown above in the chart.
How To Spot Momentum Signals
Here we teach you how to spot a buy, sell or exit signal by using the Momentum Indicator.
How to Spot a Potential Sell Signal
A momentum potential buy signal occurs when the Momentum indicator crosses above the zero line.
The crossing of the zero line implies that the price of the stock, future, or currency pair is reversing course. Either by having bottomed out or by breaking out above recent highs; this is typically viewed as a bullish signal.
How to Spot a Potential Sell Signal
Alternatively, you have a momentum potential sell signal when the momentum indicator crosses below the zero line.
A cross of the zero line can generally mean two things: the future, currency pair, or stock’s price has topped out and is reversing or that the price has broken below recent lows.
Either way, these events are often interpreted by traders as bearish signals.
How to Spot an Exit Signal
Generally speaking the potential buy and sell signals discussed above are poor exits, either selling out of a long position or buying to cover a short position.
By the time the Momentum indicator returns back to the zero line, most or all of the profits have probably eroded, or even worse the trader has let a winning position turn into a losing position.
When the Momentum is reversing course and is heading back towards the zero line, that means profits have been eroded. How much of a retracement back towards the zero line before an exit is triggered is up to the trader.
What Do Trendlines Show?
Another possible alternative is to draw a trendline; when the trendline is broken, that might act as the exit signal.
Like most technical analysis indicators, interpreting them is part science and part art.
Potential buy and sell signals are not the only use of the Momentum indicator. The next page discusses using Momentum to detect divergences, an important trading concept.
What Are Momentum Divergences?
Identifying divergences between price and technical indicators can be an important aspect of technical analysis trading.
Bullish divergences might signal a trader to exit their short position; similarly, bearish divergences could warn that prices could correct and that it might be advisable to exit any longs.
In the chart below of the S&P 500 exchange traded fund (SPY), Momentum divergences can be seen:
Reading A Bearish Divergence
The first bearish divergence occurred when price formed a double top formation.
The Momentum indicator confirmed when price of the S&P 500 ETF failed to make a higher high.
Reading A Bullish Divergence
The next divergence was a bullish divergence, where price made lower lows, yet the momentum indicator made higher lows.
This signaled that the recent downtrend was losing steam and that a bottom could be forming.
The last divergence occured because the S&P 500 ETF was increasing, but at a decreasing rate. The momentum indicator shows this perfectly, by making lower highs over the course of about 15 stock trading days.
Divergences Warn Of Reversals
Just because a stock trader or futures trader sees a divergence doesn’t necessarily mean that they should reverse their stock or futures trade.
Divergences are attempts at warning of potential reversals.
A more concrete signal, like a trendline break might have been a great signal in the last example.
Nevertheless, in this particular example, the Momentum indicator offered the stock trader plenty of time to reduce the size of their long stock position.
A similar, and arguably superior tool for measuring momentum is the Rate of Change indicator.
Where Can I Start Trading?
If you are interested in trading using technical analysis, have a look at our reviews of these regulated brokers available in to learn which charting tools they offer:
CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. Between 74%-89% of retail investor accounts lose money when trading CFDs. You should consider whether you can afford to take the high risk of losing your money.
Further Reading
Learn more about technical analysis charting concepts and strategies including Typical Price Moving Average, and Average Directional Movement. and Triangular Moving Average.
You can also find guides on different ways to trade like CFDs, options, forex, stocks, bullion, and cryptocurrencies.
FAQs
What are momentum indicators?
Momentum indicators measure the current price of a stock or asset in relation to a past price. Examples of momentum indicators include the relative strength index (RSI) is a type of momentum indicator along with the moving average convergence divergence (MACD) indicator. Both allow traders to spot buy, sell, and exit signals.
What is a momentum strategy?
Traders who use a momentum strategy use technical analysis tools like momentum indicators alongside mass index indicators and flag pattern analysis to determine whether the market will carry on moving in the existing direction. Alternatively, a momentum strategy allows traders to speculate on whether the chosen market is more likely to reverse.
