Momentum Indicator: Overview, Strategy, Examples for Forex Trading | Litefinance


Momentum indicator is a technical tool that determines the trend strength, its direction, and the further potential of the market development. Momentum indicators are used to analyse any market: Forex, stocks, commodities, cryptocurrency. The momentum indicator proves to be the most efficient in long-term trading strategies, but it can also be applied to short-term trading.

The Momentum indicator was created by the talented French mathematician Paul Émile Appell. Appell is known for his discoveries in the fields of analysis, mathematics, geometry, and mechanics. He wrote more than a hundred books, received a doctorate in mathematics, and was elected a member of the French Academy of Sciences.

The famous trader Martin Pring is considered to be the most popular promoter of Momentum. Martin Pring has been involved in a comprehensive analysis of technical patterns and indicators for many years. His market predictions are based on a long-term economic model that provides the basis for the application of technical tools. In his books on market analysis, Pring often resorted to using the concept of the Momentum indicator as an additional filter for entry signals. 

The article covers the following subjects:

What is Momentum Trading (MTM) in Stock? Definition & Meaning

The Momentum or MTM indicator is used to analyse the trend direction, its strength and determine the potential pivot points.

MTM is a simple leading indicator, its reading is quite straightforward. If the indicator is rising and stays above some median line, the trend is up. If the indicator is going down and stays below the median, the trend is down.  

The momentum compares the last closing price with the closing price n periods ago and gives a digital conclusion, according to which a momentum trader determines whether it is profitable to buy or sell, what is a potential profit for a trade, and whether a trend should reverse soon.

Many traders often refer to the Momentum as an oscillator, but it isn’t accurate. The MTM indicator can be utilized both as an oscillator and as a trend indicator. 

The momentum indicator in stocks trading is most often employed in the daily chart to determine the current market financial situation, the trend strength, and the price direction. Traders in the stock market often use momentum as a supplementary tool to filter entry signals. The main idea is that the indicator readings should correspond to the news about the company’s performance.

How does Momentum Indicator Work?

The indicator compares the current closing price with the closing price n periods ago, and the results are reflected as a broken line in the chart. The readings of the indicator make up key points in the chart, highs and lows that could be easily seen. By analysing these extreme points, a trader decides how to use the momentum indicator:

  • If the indicator line is above zero line, the trend is upward. If the indicator is below the zero line, the trend should be down.

  • If the momentum draws an extremely high or low, the current trend should continue. 

  • If the price draws the next high higher than the previous, and the Momentum high is, conversely, lower than the previous, the ongoing uptrend could be exhausting, the momentum is weakening, and the price should soon start falling. 

  • If the price chart draws the next low lower than the preceding one, and the Momentum low is higher than the previous one, the ongoing downtrend could be exhausting, the momentum is weakening, and there should soon start a correction or the trend reversal. 

Note: the latter two cases are called divergence and convergence, and the Momentum indicator serves as an oscillator in such situations. One should take into account that the trend could continue after slowing down, so, the divergence signals should be confirmed by other tools

Momentum Indicator Formula for Calculations

There are several formulas for calculating this indicator. One of the most popular momentum calculation formulas is the one offered by John J. Murphy in his book Technical Analysis of the Financial Markets. Murphy advises calculating the momentum value as a difference in the closing prices of the current and past (a certain number of bars back) periods:

M(j) = CLOSE(j) – CLOSE(j – n), where

M(j) — Momentum reading;

CLOSE(j) — the most recent closing price;

CLOSE(j – n) — closing price n periods ago.

This formula shows that the Momentum indicator is the difference between the most recent closing price and the closing price n periods ago. The n factor is determined by the trader independently and is specified in the indicator settings. By default, factors n equal to 10 or 14 are used. An indicator value of 21 is often encountered.

Based on the formula advised by John Murphy, the momentum reading could be either positive or negative.  

Some traders considered the value of the indicator, fluctuating around 0, not very convenient, so Steve Achelis, in his book Technical Analysis from A to Z, offered the following momentum calculation formula: 

M(j) = CLOSE (j) * 100 / CLOSE (j – n), where

M(j) — Momentum;

CLOSE(j) — most recent closing price;

CLOSE(j – n) — closing price n periods ago.

The difference between the second version of the formula and the first one is that the indicator is expressed in relative terms and its readings fluctuate not around zero, but around the level of 100. It is not that significant which formula to use.

How To Read Momentum Indicator?

The primary function of the tool is to determine the price trend direction. Let us explore this moment in terms of speeding up and slowing down the trend.

Imagine that the market suddenly makes a strong move up or down. It could be traders’ reaction to the news released, or it may be the result of a major manipulation by a big trader. Regardless of the cause, such a movement will be called an impulse movement or momentum.

The price momentum in the chart means that the trend is speeding up. The momentum indicator will be rising. As the trend slows down, the momentum readings will be declining.

Momentum in trading is the rate of the asset price change over a specified period of time:

  • The faster the current price rises, the greater will be the momentum value growth.

  • The faster the current price declines, the greater will be the momentum value fall. 

The momentum indicator: description and application. Key takeaways:

  • If the momentum indicator is above the 0 level, the trend is up.

  • If the momentum indicator is above the 0 level and the indicator readings are rising, the uptrend is speeding up. This means that the current uptrend is strong, and the price should continue rising.

  • If the momentum indicator starts to decline but is still above the 0 level, the trend remains up, but the price long-term growth is slowing down. This means the uptrend is exhausting but the trend may not reverse. 

  • If the momentum indicator is below the 0 level, the trend is down.

  • If the momentum indicator is below the 0 level and the indicator readings are declining, the downtrend is speeding up. This means that the current downtrend is strong, and the price should continue falling. 

  • If the momentum indicator starts to rise but is still below the 0 level, the trend remains down, but the price fall is slowing down. This means the downtrend is exhausting but the trend may not reverse. 

Momentum Potential Buy Signal

When the momentum line breaks out the zero level upside, there is a potential buy signal. It means that the price of equity, futures, or a currency pair is starting an uptrend or an ascending correction.

Momentum Potential Sell Signal

When the momentum line breaks out the zero line downside, there is a potential sell signal. It means that the price of equity,  futures, or a currency pair is starting a downtrend or a descending correction. 

Momentum Potential Exit Signals

When the momentum indicator returns close to the zero level, it could serve as a potential exit signal. However, if a trade exit is based on such a signal alone, you could lose a significant part of the potential profit or even suffer a loss.

To avoid this, some traders focus on how much the indicator has risen or fallen compared to the previous data. If the indicator line has deepened far down, then it is time to take profit from the sell trade. If the indicator line has grown significantly in relation to level 0, then it is time to take profit from the purchase.

The second variant of an exit signal is when the indicator crosses its trendline. Once the trendline is broken out in the direction opposite to the trade direction, it is time to close the position. 

Another variant of an exit signal is to close a position when there is a divergence between the price chart and the indicator line. For example, a signal to exit a sell trade in the chart below will be when the price breaks through its local low while the momentum indicator fails to make a lower low.

Studying the above examples, we can conclude that the interpretation of signals is a complex approach. You should understand the current market sentiment and refer not only to indicator signals but also take into account the rules of your trading strategy.

How to Apply Momentum in MT4

The momentum indicator is in the standard indicator list of the Meta Trader platform. To apply the Momentum oscillator in the MetaTrader 4 trading terminal, one should follow these steps:

  1. Enter the “Insert” menu.

  2. Click on the “Indicators” tab.

  3. Choose the “Oscillators” group.

  4. Select “Momentum”

In the momentum indicator settings, you can specify the Period (the default one is 14). Next, you can choose the price, based on which the indicator is built (opening, closing, high, low). The “Apply to” parameter is recommended to be Close. You can also choose the colour and the type of the indicator line, fix the high or low.

You can add more levels if you need them in the Levels menu. It is recommended to add level 100, so you will have the median indicator line. To add the needed level, you should click on the Add button and enter the corresponding value.

After you specify and activate all necessary parameters, click on the OK button, and the momentum indicator will appear under the price chart, at the bottom of the MetaTrader terminal. 

How to Apply Momentum in the LiteFinance terminal

To enable the momentum oscillator in the LiteFinance trading terminal, follow the instruction below:

1. Sign in to your Client Profile.

2. Click on the Trade tab in the left menu.

3. Open the price chart of the needed trading instrument.

4. Click on the Indicators menu in the price chart.

5. Enter Momentum in the search bar, and select the Momentum Oscillator in the list on the right.

6. Close the indicator list and you will see that the momentum has appeared under the price chart.

To configure the momentum parameters, click on the gears icon on the left of the indicator name.

The LiteFinance trading terminal provides the following settings: Length, Source, and Style. The Style menu offers the settings of the line’s colour and type.

The momentum calculation formula on the LiteFinance terminal is the classic one. It means that the indicator readings will be bigger than 0 or less than 0, depending on the ongoing trend.

The centreline is added in the following way: 

1. In the drawing menu in the toolbar on the left of the Chart window, choose the Horizontal line.

2. Draw the centre line yourself directly in the indicator window, setting it to level 0.

How to Measure Stock Momentum on Forex?

To reduce market noise, technical analysts usually use the momentum indicator with period 21 in the daily timeframe. This number of periods allows measuring a short-term trend that usually continues during a month.

The chart below displays the momentum indicator in the S&P 500 chart. I want to explain how to measure momentum, so I deleted the prices of the index itself from the figure to display only the momentum chart.

Let us see how to calculate stock momentum. If the most recent closing price of the S&P 500 is higher than the closing price 21 days ago, the indicator line will be above the zero line. And vice versa, if the most recent closing price of the S&P 500 is lower than the closing price 21 days ago, the indicator line will be below the zero line.

The zero level is the zone where an index or a stock is trading in a sideways trend or isn’t trending at all. Once the price movement becomes impulsive (speeds up), the bullish or bearish trend accelerates, the momentum line (purple) goes away from the zero line (black).  

Without looking at the S&P 500 price and using only the momentum indicator, we could assume that the S&P 500 price was rising along with the indicator’s highs above the zero level. And vice versa, the index must have been falling along with the downward movements of the Momentum below the zero level.

If we look at the S&P 500 price chart with the Momentum chart, we will see that the price corresponds or quite closely correlates to the indicator readings. 

  • In September 2021 (the left part of the chart) the momentum started moving below 0, and the S&P index was also falling and reached a price level of 4300.

  • In November 2021, the momentum line went above 0, and the S&P 500 price started rising and hit another high around 4700.

  • From November 30 to December 22, 2021, (the middle of the chart) the momentum indicator was swinging around the zero line, while the S&P 500 was trading sideways.

  • In late December 2021, momentum started rising, and the stock index price was also growing and hit a new high of 4800.

  • After the momentum fixed below the zero level in late January 2022, the S&P has been trading down, which is confirmed by the indicator readings (the right part of the chart). 

The example above shows that if the stock momentum indicator is above zero, but not trending higher, then this could eventually cause the S&P 500 price to fall, as in the case from mid-November to the end of November 2021 (dashed orange box).

Many investors and traders watch the charts of the Momentum indicator and the S&P 500. If they do not move in sync, there is a non-standard situation. Therefore, the S&P 500 and the Momentum must synchronize, so that the asset price will resume trending.

Momentum Trading Strategies

There are several profitable strategies to trade with the Momentum indicator. They could be used independently or combined together. The choice of the trading platform or a trading instrument will not affect the Momentum trading performance.

Momentum breaks through level 100

This is quite a simple Momentum trading strategy that suggests entering a trade when the indicator breaks through level 100.

The period to trade in the daily timeframe is 21. The strategy is employed in the trending market.  

Rules to trade:

  1. Identify the current trend (visually or using trend indicators).

  2. If the trend is up, the Momentum indicator should break out level 100 upside to send a buy signal.

  3. If the trend is down, the Momentum line should break out level 100 downside to send a sell signal.

A stop loss is set above the previous local high or below the previous local low (depending on the trade direction).

You exit a trade when the indicator line breaks through the previous local high or low. The second option to exit a trade is to take the profit when the momentum indicator deviates by a significant value.

Momentum and Moving Average

To filter the Momentum signals, many traders like to add the Moving Average to the indicator. In this case, an entry signal appears when the Momentum line crosses the Moving Average.  

Momentum indicator entry and exit signals:

  1. A buy signal is when the Momentum crosses the MA from the bottom up.

  2. A sell signal is when the Momentum crosses the MA from the top down.

When the Momentum is applied together with the MA, level 100 is not used.

A Stop Loss is set beyond the local high/low.

A trade is exited when the Momentum significantly deviates. 

Momentum as an Oscillator

You can use the Momentum indicator as an oscillator if you reduce the Period value. In this case, the indicator will often cross level 100 and move close to the indicator window borders. When the Momentum is close to the window borders, it will signal that the market is overbought or oversold.  

How to use Momentum oscillator 

  1. The Momentum period is 3

  2. When the Momentum significantly deviates up, there is a sell signal.

  3. When the Momentum significantly deviates down, there is a buy signal. 

The Momentum Oscillator trading strategy works well when there is no strong trend in the market or when the market trading momentum is exhausting.

As the Momentum amplitude is not limited, you will have to identify the overbought and oversold levels for each traded instrument yourself, based on historical data and the period specified in the settings. It requires some experience and understanding of the current market opportunities.

Momentum as trend indicator

The Momentum indicator can identify a trend if the period is quite high. To determine a short-term trend (up to one month) the period of 21 is suitable. In this case, will be a trend indicator.  

Note: you should choose the period value yourself for each particular asset and its volatility. Traders most often use the following periods: 10, 14, 20, or 21.

How to read the Momentum trend indicator:

  • If the indicator line is above level 100 and is breaking through its local highs, the trend is up.

  • If the indicator is below level 100 and is breaking through the local lows, the trend is down.

The trend strength is determined by the rate of the line deviation from level 100. The greater is deviation the stronger is the trend.

Divergence

A good entry signal is the divergence between the price chart and the momentum indicator.

Divergence means that the price chart and the indicator are moving in opposite directions.

  • If the price is rising and hits a new high, and the forex momentum indicator is going up but doesn’t make another high, this is a bullish divergence, a sell signal.

  • If the price is falling and hits the new low, and the momentum is also falling but doesn’t make a new low, this is a bearish divergence, a buy signal. 

To identify a divergence in the bullish market, you need to draw a line along with the most recent highs in the price chart and do the same with the indicator. Divergence appears when these two lines go apart. The wider is the divergence, the stronger is the signal.

To identify divergence (it is sometimes called convergence) in the bearish market, you need to draw a straight line along with the lows in the price chart and in the indicator chart. When the lines come closer to each other, there is divergence. The narrower is the distance between the lines, the stronger is the signal. 

As you see from the above Brent Crude Oil chart, there are four signals of divergence during the period from March 2017 to February 2018

  • The first buy signal appeared after the price broke through the previous low, but the momentum indicator only reached its previous low. In this case, the two lines started moving to each other (convergence).

  • In the second and the third cases, the price was corrected down each time after the price set another important high, but the indicator reached only the previous high, going slightly above.

  • In the fourth case, the Brent price made another high, and the Momentum made a lower high. This was a strong signal, and the price went down significantly. 

When you trade divergence signals, you should also analyse the situation on longer timeframes. The test results report showed that during strong trends, momentum divergence can give a false signal, so such signals should be supported by additional technical analysis tools, indicators, price action patterns, and factors of fundamental analysis.

The key support and resistance levels will also be a helpful tool when trading divergence. The Bollinger Bands could serve as an additional filter to enter or exit trades.  

Overbought/Oversold zones

As the Momentum amplitude is not limited, you have to define overbought and oversold zones yourself for each traded instrument, based on historical data and the period specified in the settings.  

Let us study the USD/CHF chart In the example below. The USD/CHF doesn’t tend to sharp or deep movements. The average daily volatility of the instrument (ATR) was 62 pips in March 2022. 

Set the indicator period so that the Momentum will serve as an oscillator. Most traders set a period of 3 in this case. For other instruments, the period may be changed, everything depends on the volatility and features of the trading instrument, so, this moment needs tests. 

The daily USD/CHF chart shows that the indicator forms its highs when the deviation is 1.5%…2%. The lows are made in the zone of -1.5%…-2.0%. These ranges will serve as the overbought/oversold zones. 

  • In the above example, the overbought zones are highlighted in red. After reaching these zones, the market was overbought, and investors didn’t want to buy the asset at unfavourable prices.

  • The oversold zones are highlighted in blue. Upon reaching these zones, the price was rising, as the market was oversold, and more favourable prices were needed to enter new trades. 

The overbought and oversold zones in the market give the trader an idea of where the price can be stopped and a reversal, or at least a correction, can occur. With proper use of these zones, a trader can make profits from both the price fall and its rise.  

Overbought/oversold zones provide potentially profitable signals in a sideways trend. In strong uptrends and downtrends, these zones can indicate the levels of take-profits. 

Momentum day trading strategies

The momentum indicator can be employed in intraday trading. In this case, you need to add two Momentum trading indicators with different periods:

  1. Momentum with the period of 24 helps to define the general trend

  2. Momentum with the period of 4 serves as an oscillator and generates trading signals. 

Momentum day trading strategy:

  • If the momentum line (period 24) is above level 100, the trend is up.

  • If the momentum line (period 24) is below level 100, the trend is down.

  • If the momentum line is swinging around level 100, the market is not trending, and it is not recommended to trade.

  • Enter a buy trade when the trend is up, and the momentum oscillator (the one with the shorter period) consolidates below level 100.

  • Enter a sell trade when the trend is down, and the momentum oscillator (the one with the shorter period) consolidates above level 100. 

In the above figure, the black box marks potential trading signals in the AUD/USD chart (timeframe H1). 14 signals were formed over ten trading days. If you enter trades based on all signals, there will be 10 winning trades and 4 losing ones. Potentially losing trades are marked with red dotted arrows labelled StopLoss in the indicator window. 

Momentum in stock trading 

Trading stocks using various momentum strategies is no different from trading other instruments using this indicator. Momentum stock trading involves choosing the indicator period for each stock individually, depending on its volatility and the nature of price movements.

The most effective signals in stock trading are generated by two momentum trading indicators with different periods. The momentum with a longer period is used to determine the trend, and one with a shorter period serves as an oscillator.

Best Momentum Indicators for Stock&FX Trading

Many popular oscillators have been created based on the Momentum indicator. The most popular ones are Relative Strength Index, MACD, and Stochastic Oscillator. These indicators define the market situation, signal the overbought and oversold zones. Below I will describe the most popular momentum indicators in stock trading and forex.

The relative strength index (RSI)

As you can see from its name, the RSI indicator defines the trend strength and the likelihood of trend reversal. The RSI is an oscillator, whose readings are presented as a dynamic line moving in the scale from 0 to 100

This indicator measures the momentum, the velocity, and magnitude of price movements. The stronger is the relative price movement up, the greater is the indicator reading. The oscillator line is close to value 100.  The stronger is the relative price movement down, the closer the oscillator line to 0.

To utilize the RSI indicator more efficiently, traders add to the indicator chart the so-called overbought and oversold zones. Overbought and oversold zone ranges are determined separately for each trading instrument. There are several standard ranges for overbought zones.

  1. 80 – 100

  2. 70 – 100

  3. 60 – 100

The typical oversold zones are:

  1. 0 – 20

  2. 0 – 30

  3. 0 – 40

Based on the instrument type (currencies, commodities or stocks) and its volatility, traders usually choose one of the three ranges listed above.

Major principles of trading with the RSI indicator:

  • When the indicator line enters the overbought zone, there is a potential sell signal.

  • When the indicator line enters the oversold zone, there is a potential buy signal.

  • To analyse the trend in the daily chart, one should set the indicator period of 21.

  • In the stock market, the overbought/oversold zones usually have a wider range, about 40%

  • In the forex market, the oversold/overbought zones are narrower, about 30%.

In the above example, potential signals to buy the stocks of The Boeing Company in the oversold zone are marked by red boxes. Sell signals are marked by blue boxes.

As you see, the RSI indicator provides information when it is relevant to enter a buy or sell trade.

Moving averages (MACD)

The MACD (Average Convergence/Divergence) indicator is also an oscillator. It is a very popular and simple indicator that can be used to analyse any trend.

The indicator is composed of three elements:

  1. The MACD line is the difference between the slow EMA and the fast EMA. The MACD line is quite fast.

  2. The signal line is the EMA calculated based on the MACD line. Differently put, the MACD line is flattened using a simple moving average to filter signals. It is a slow line.

  3. The MACD histogram is a visual display of the interaction between the MACD line and the signal line. It calculates the difference between the MACD line and the signal line. The greater is the divergence between the MACD and the signal line, the higher are the bars in the histogram. 

One of the most accurate signals of the indicator is the divergence between the MACD and the price chart.

  • When the price is rising and forms a greater high than the previous one and the MACD is also rising, but the new highs are lower than the previous ones, there is a momentum bullish divergence, a sell signal.

  • When the price is falling, and each next low is lower than the previous one and the MACD is also falling but makes higher lows, there is a momentum bearish divergence, it is a buy signal.

A popular MACD trading strategy:

  • By default, period 12 is set for the fast MA and period 26 – for the slow one.

  • Trades are entered when divergence appears in the chart.

  • You enter a sell trade after the close of the next signal candlestick, whose histogram bar in the indicator window will be lower than the previous one.

  • You enter a buy trade after the close of the next signal candlestick, whose histogram bar in the indicator window will be higher than the previous one.

  • You should also attach an additional channel to the chart – a simple moving average with the period of 12 and its smoothed variant (EMA) with the period of 26 to take the profit in the future.

StopLoss is above the most recent high or below the most recent low.

TakeProfit is set at the far border of the attached channel (the EMA 26 line in the orange MA in the chart).

In the above example, the divergences, potential signals, are marked with purple in the chart. Black arrows point to the entry points. Black dotted boxes mark the TakeProfit levels.

Let me explain the signals to trade Amazon stocks:

  1. After the first sell signal appeared in July 2021, the price didn’t reach the TakeProfit level (orange EMA) during the first decline. Next, following a short correction, the market opened with a gap, and the profit was greater than it would have been if the position had been closed at the EMA line.

  2. When the second sell signal appeared, the price didn’t reach the TakeProfit level and the position was closed by the Stop Loss.

  3. The third signal formed when divergence continued and the price broke through another high in the chart. The histogram bars can’t make a new high. There is a triple divergence and a good profit from the sale.

  4. The fourth signal, a signal to buy, appeared in late January 2022. It is remarkable because the MACD histogram broke slightly below the previous low. However, if you compare the line connecting the local lows of the price chart and the line connecting the local lows of the histogram, you will see a significant divergence between the lines. It is also interpreted as a signal.

In conclusion, I want to note that you can choose other parameters for the MACD periods that you consider more efficient. There are no strict rules. Also, you should correlate the divergence signals with the longer-term trend, the long-term timeframe should not contradict the signals in the short-term chart.

The Stochastic Oscillator

The Stochastic Oscillator or just stochastic is in the standard tool kit in many trading terminals. The stochastic signals are easy to interpret, that is why it is quite popular among traders. Like most oscillators, stochastic ranges from 0% to 100%, generating overbought and oversold trading signals.

A stochastic oscillator is a momentum indicator comparing a particular closing price with the price highs and lows over a certain period of time. Differently put, the indicator shows where the price is relative to its recent traded range. The traded range is selected by the indicator period.

The indicator is composed of:

  • Blue line – stochastic line (fast)

  • Orange line – moving average of the stochastic line (slow)

  • Overbought zone – the range of 80% – 100%

  • Oversold zone – the range of 0% – 20%  

Major rules to trade with Stochastic:

  • The indicator parameters had better be default (14; 1; 3). Experienced traders may try to change parameters and experiment.

  • The most reliable signals are generated when the Stochastic enters the oversold/overbought zone and then exits it.

  • A quite strong signal is a divergence between the price and the indicator.

  • Stochastic allows trading in a sideways trend and anticipates potential corrections after a momentum.

  • Crossovers of the blue and orange lines suit to trade in the trend direction.

An example of using the Stochastic indicator with a combination of sell signals:

  1. Expect when the stochastic lines enter the overbought zone.

  2. When the fast Stochastic line breaks through the slow one, be prepared to enter a sell trade.

  3. An entry signal will be the moment when the fast line goes back to the range of 20% – 80%.

An example of using the Stochastic indicator with a combination of buy signals:

  1. Expect when the stochastic lines enter the oversold zone.

  2. When the fast Stochastic line breaks through the slow one, be prepared to enter a buy trade.

  3. An entry signal will be the moment when the fast line goes back to the range of 20% – 80%.

Rate of change (ROC) 

The Price Rate of Change (ROC) is a momentum-based technical indicator that measures the change in price between the current price and the price a certain number of periods ago, expressed in percentages. Depending on the period, the ROC indicator could be used both as an oscillator (period 5-14) and the trend indicator (period more than 20). Most commonly, the ROC indicator is utilized as an oscillator.

The default period is 9, the indicator is applied to closing prices. 

The indicator is plotted against zero and its deviations from the zero level or divergences generate signals.

  • When the ROC rises above zero, the market is overbought

  • When the ROC goes below zero, the market is oversold.

  • You can mark the overbought and oversold zones in the indicator window, drawing the line along with the historical highs and lows.  

An example of trading with the Rate of Change:

The above figure displays the AMD stock chart. Blue boxes mark potential sell signals when the ROC is in the overbought zone. Red boxes mark potential buy signals when the ROC is in the oversold zone. The dotted lines mark divergences.

Commodity Channel Index (CCI) 

The Commodity Channel Index (CCI) is a momentum oscillator used to determine the overbought and oversold market levels.

The CCI indicator measures the difference between the current price and the historical average price. Differently put, the indicator analyses the relation between the price and the moving average.

Originally, the CCI trading strategy was developed for the commodity market but performs quite successfully in other markets: currencies, stocks, indexes, etc.

The indicator has the following settings: 

Traders who use this indicator for the first time are advised to leave the default values.

Trading with the CCI is similar to using other oscillators:

  • If the indicator signal line goes beyond +100 points, the market is overbought.

  • If the indicator signal line goes beyond – 100 points, the market is oversold.

  • The divergence between the price chart and the indicator line signals a potential trend reversal.

  • Generates reliable signals in a flat. In strong trends, could send a lot of false signals.

 Let us study the example of trading Netflix stocks using the CCI.

In the above figure, the dotted boxes mark the points where the indicator signal lines enter overbought/oversold zones and the trend reverses. Dotted lines mark divergences generating potentially profitable signals to enter a trade counter the trend.

Momentum Indicators Advantages and Disadvantages

The Momentum indicator could be used as a trend indicator and as an oscillator. It generates quite many signals, the indicator is easy to set and can be used in all kinds of markets. For profitable trading, one should utilize the momentum indicator together with other technical analysis tools. 

Momentum pros

Momentum cons

Clearly defines the current market trend

Sends many false signals in strong trends

Efficiently spots divergences

It is not a self-efficient trading system and should be supplemented by other tools for profitable trading

Determines the overbought/oversold market zones

If the period is not appropriate, the indicator could send false signals 

Identifies strong momentum moves when used together with other trend indicators

Poor exit signals

A leading indicator that could anticipate the potential price reversals

 

Momentum Indicators: Summary

The Momentum Indicator, like other oscillators based on it, is very popular among traders. Although the tool was developed a long time ago, it is still useful in trading.

The Momentum Indicators can be used to analyse any financial instrument, trading asset, and any market: foreign exchange, oil, gas, cryptocurrencies, stocks, stock indexes, binary options, etc.

Most traders like the simplicity and straightforwardness of the indicator. If you set a longer period, you can define the trend, or you can use the momentum with a shorter period to spot the overbought/oversold zones.

Like most oscillators, the momentum indicators perform quite well in a sideways trend. The Momentum determines divergences that are often preceding a price correction or a trend reversal, allowing to make a greater profit.

It should be noted that a limitation of the momentum indicator is that one needs to filter signals using other technical tools in clear trends.

Summing up, I can safely say that the Momentum Indicator is an efficient tool for both experienced traders and newbies. One can develop an own trading strategy based on the Momentum indicator combined with other technical tools. 

The content of this article reflects the author’s opinion and does not necessarily reflect the official position of LiteFinance. The material published on this page is provided for informational purposes only and should not be considered as the provision of investment advice for the purposes of Directive 2004/39/EC.

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