Applying the Momentum Indicator to Trading Strategy
Understanding the momentum indicator can help gauge price movement
It is possible to identify the strength of a price movement by using the momentum indicator calculation. This formula compares the most recent closing price to a previous closing price from any time frame. The momentum indicator is displayed as a single line, on its own chart, separate from the price bars, and is the bottom section in the example chart.
Calculation of the Formula
There are several variations of the momentum indicator, but whichever version is used, the momentum (M) is a comparison between the current closing price (CP) a closing price "n" periods ago (CPn). The "n" is determined by you. In the attached chart, momentum is set to "10," so the indicator is comparing the current price to the price 10 minutes ago (because it is a 1-minute chart).
M = CP - CPn
M = (CP / CPn) * 100
The first calculation just takes the difference between the two closing prices and plots it. The second version of the indicator shows the price difference between the current price and the price "n" periods ago as a percentage.
The momentum indicator identifies when the price is moving upwards or downwards, and by how much. When the momentum indicator is above 100 or 0, the price is above the price "n" periods ago, and when the momentum indicator is below 100 the price is below the price "n" periods ago.
How the far the indicator is above or below 100 indicates how fast the price is moving. A reading of 101 shows the price is moving quickly to the upside than a reading of 100.5. A reading of 98 shows the price is moving with more force to the downside than a reading of 99. If the indicator shows a zero line, a reading of 0.35 means there is more upside momentum than a reading of 0.15.
The momentum indicator can be used to provide trade signals, as follows, but it typically is better used to help confirm trades based on price action (breakouts or pullbacks within a trend, as examples).
100 Line Cross: When the price crosses above or below the 100 line (or zero line if the indicator is based on the first calculation) it can represent a buy or sell signal respectively. If the price crosses above the 100 line it indicates the price is starting to move higher since the price has moved above the price "n" periods ago. A drop below the 100 line shows the price is dropping since it has moved below the price "n" periods ago.
The 100 or zero line cross is prone to "whipsaws," meaning the price could move above the line, but then right back below it. Traders may wish to filter signals based on the current trend. For example, if a stock is trending higher, only buy when the indicator falls below zero/100 and then rallies back above zero. In this case, the indicator can also be used as a sell signal when it dips below 100/0.
Crossover: Add a moving average to the indicator. Buy when the momentum indicator crosses above the moving average from below, and sell when the momentum indicator crosses below the moving average from above.
This too has its problems, mainly the whipsaw problem mentioned above. This can be somewhat alleviated by once again only taking trade signals in the trending direction, as described above. In this case, if the trend is down, only take short trades after the indicator has moved above the moving average and then drops below. Exit the short trade when the indicator moves above the moving average.
Since there are now two indicators being used, you will need to test out various moving average lengths and momentum indicator setting to find a combination that works for your trading style.
Divergence: If the price is moving lower, but the lows on the momentum indicator are moving higher, this is a "bullish divergence." It shows that while the price is dropping, the momentum behind the selling is slowing. If you get a buy signal, this bullish divergence can help confirm it. If the price is moving higher, but the highs on the momentum indicator are moving lower, this is a "bearish divergence." It shows that while the price is rising, the momentum behind the buying is slowing. If you get a sell signal, this bearish divergence can help confirm it.
Divergence should never be used on its own, as it is not reliable. It should only be used to help confirm trade signals produced by other strategies. If using the indicator for divergence, be aware of the quirks of the indicator. For example, if the price rises strongly but then moves sideways, the momentum indicator will rise and then start dropping. This is not a bad sign. The indicator is just showing, in a different way, what is visible on the price chart: the price had a lot of momentum, and now it has very little (dropping momentum), but that doesn't mean the price is going to drop.
Not a Solution for Everything
The momentum indicator is not going to give a trader much information beyond what can be seen just by looking at the price chart itself. If the price moves aggressively higher, this will be visible on the price chart and on the momentum indicator. The momentum indicator can, however, be useful for spotting subtle shifts in the force of buying or selling though, mainly through the use of divergence (but be aware of the quirks). The formula is best used in conjunction with a price action trading strategy, providing confirmation as opposed to using the indicator to generate trade signals on its own.