A momentum indicator allows for a quick comparison of a security’s current price relative to its past prices using a flexible time period, allowing traders to decide the parameters. The formula to calculate momentum is M = V – Vx (where V is the current price and Vx is the closing price from x number of days ago). A current price in excess of past price is a positive momentum indicator; a lower current price represents negative momentum.
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Trade Signals
The momentum indicator is regarded for its simplicity. Traders typically interpret a momentum indicator crossing above zero to indicate a positive reversal of previous negative trends or a sign of continued growth from an already upwards trajectory. Movement below the zero line indicates the opposite: a security reversing course or trending lower (see Trade-Ideas below).
Like most trade signals, timing is vital to maximize the momentum indicator. The closer a number to returning to the zero line, the greater the likelihood that a trader has lost whatever profits they had earned by holding on too long to a security. Some traders use trendlines to determine when to exit; where that trendline is set depends on the individual strategy.
Divergences
Divergences are useful signals of potential reversals in trajectory but should be treated as a supplement to information garnered from other strategies. When used properly, traders who recognize divergences between momentum indicators and prices can benefit from more certainty in their decision-making.
A trader who notices a double top formation, for example, can use a momentum indicator to confirm that an asset is unable to top its previous high point, perhaps indicating a time to sell to maximize gains. A price that appears to be reaching new lows can be confirmed via momentum indicator to be performing better than expected, indicating a potential bottom (and a good time to buy). A bullish-looking market can be shown, using a momentum indicator, to be increasing at a reduced rate, representing slowing momentum. While divergences do not guarantee a trader any outcome, they can offer early signals with which to maximize gains or minimize losses.
A Complementary Tool
The momentum indicator is a simple (but potentially effective) tool. While it may not provide much insight beyond what is already visible on a price chart, it can help a trader better quantify subtle ups and downs in an asset’s behavior. That knowledge, when combined with signals from other tools, can confirm decision-making rationale and allow a trader to make better-informed trades.
Technology has improved the accuracy of technical indicators and increased a trader’s odds of success, especially because no single indicator works well for all securities. There are myriad ways to use technical analysis in trading, and which indicator or methodology a trader decides to use usually depends on their experience, skillset, and the quality of the tools (A.I.) available to help them find trade ideas.