Applying the Momentum Indicator to Your Trading Strategy

At times stock prices fall fast, but at other times they may fall slow. You can figure out on your own how fast a price has changed by using the momentum indicator line in a price chart. The formula for this price indicator compares the most recent closing price to a previous closing price from any time frame. Most of the time, the momentum indicator is shown as a single line in a different section of a chart from where you see the price line or bars.

Figuring Out the Momentum

The momentum of a price is pretty easy to find. There are a couple of 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."
Version 1: M = CP – CPn
Version 2: M = (CP / CPn) * 100

The first version simply takes the difference between the two closing prices. The second version finds momentum as the rate of change in the price and is shown as a percentage.

The momentum indicator finds out 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 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% shows the price is moving down with more force than a momentum of 99%.

Trading Use

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. There are a few ways you can look at the indicator to see where a stock might go.

100 Line Cross

The 100 Line Cross is one strategy traders use. 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 mean a buy signal if it is above, and a sell signal if it is below. If the price crosses above the 100 line, the price is starting to go higher. A drop below the 100 line shows that the price is dropping.

The 100 line cross is prone to "whipsaws." That means the price could move above the line but then fall right back below it. Traders may wish to filter signals based on the current trend. For instance, 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, you could do a short sale. That means selling borrowed shares of a stock with the intention of buying them back and returning them later at a lower price when it drops back below the line.

Crossover

To buy or sell on a crossover, add a moving average line to your indicator. The moving average is the average closing price over a previous number of days you select.

This strategy means buying 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 method has its problems, too. The main problem is that same whipsaw issue, which can be somewhat fixed by once again moving only on trade signals in the trending direction. In that 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 basic 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, that 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.

You should also be aware of the quirks of this indicator. For instance, if the price rises strongly but then moves sideways, the momentum indicator will rise and then start dropping. That 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 movement, and now it doesn't, but that does not always mean that the price is going to drop.

Notes of Caution

The momentum indicator isn't going to provide much insight beyond what can be seen just by looking at the price chart itself. If the price is quickly moving higher, it 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 stocks, mainly through the use of divergence. The indicator is best used to help confirm a price action trading strategy, instead of using it to find trade signals on its own.

Frequently Asked Questions (FAQs)