Applying the Momentum Indicator to Your Trading Strategy
You can identify the strength of a price movement by using a momentum indicator line in a price chart. The formula for this indicator compares the most recent closing price to a previous closing price from any time frame. The momentum indicator is typically displayed as a single line in a different section of a chart than the price line or bars.
The momentum of a price is very easy to calculate. There are couple different versions of the formula, but whichever one is used, the momentum (M) is a comparison between the current closing price (CP) and a closing price "n" periods ago (CPn). You determine the value of "n."
M = CP – CPn
M = (CP / CPn) * 100
The first version simply takes the difference between the two closing prices. The second version calculates momentum as the rate of change in the price and is expressed as a percentage.
The momentum indicator identifies when the price is moving upward or downward and how strongly. When the first version of the momentum indicator is a positive number, the price is above the price "n" periods ago. When it's a negative number, the price is below the price "n" periods ago. When the second version of the momentum indicator is a percentage higher than 100, the price is above the price "n" periods ago. When it's a percentage lower than 100, the price is below the price "n" periods ago.
How the far the indicator is above or below zero or 100 indicates how fast the price is moving. For the first version, a difference of 0.35 means there is more upside momentum than a difference of 0.15. For the second version, a momentum of 98 percent shows the price is moving down with more force than a momentum of 99 percent.
The momentum indicator can be used to provide trade signals, but it is better used to help confirm the validity of trades based on price actions such as breakouts or pullbacks.
100 Line Cross: When the price crosses above or below the 100 line (or the zero line if the indicator in a chart is based on the first type of calculation), it can represent a buy or sell signal respectively. If the price crosses above the 100 line, the price is starting to gain momentum higher. A drop below the 100 line shows the price is losing momentum.
The 100 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, buy only when the indicator falls below the 100 line and then rallies back above it. If a stock is trending lower, do a short sale—selling borrowed shares of a stock with the intention of buying them back and returning them later at a lower price—only when it drops back below the line.
Crossover: To buy or sell on a crossover, first add a moving average line to your indicator. The moving average is the average closing price over a previous number of days you select.
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 strategy has its problems, too, mainly that same whipsaw issue. That problem can be somewhat alleviated by once again responding only to trade signals in the trending direction. In this case, if the trend is down, make a short trade only 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.
You should test various moving average lengths and momentum indicator settings to find a combination that works for your trading style.
Divergence: A bullish divergence occurs when the price is moving lower but the lows on the momentum indicator are moving higher. 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 as a trading signal on its own; it should only be used to help confirm trade signals produced by other strategies.
You should also be aware of the quirks of this 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 doesn't. But that does not necessarily mean the price is going to drop.
The momentum indicator isn't going to provide much information beyond what can be seen just by looking at the price chart itself. If the price is moving aggressively higher, this will be visible on the price chart as well as on the momentum indicator.
The momentum indicator can sometimes be useful for spotting subtle shifts in the force of buying or selling, mainly through the use of divergence. The indicator is best used to help provide confirmation of a price action trading strategy, as opposed to using it to generate trade signals on its own.
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