The momentum indicator is one of the most popular trading tools that is commonly used in both short-term and long-term trading. Here's how you use it in strategies.

Sometimes, we may find that the prices on financial markets move really fast, but other times they move slowly. Such various conditions are essentially caused by momentum. In physics, the term "momentum" refers to the quantity of motion of a moving body. For instance, you could say that an accelerating car is "gaining momentum". This concept is sometimes applied to non-physical situations as well, such as price movement.

momentum indicator

In financial markets, prices can gain or lose momentum for many reasons. It can be caused by various events on the forex calendar such as earning reports and huge economic news, or it can be caused by more technical reasons. Many traders like to use these momentums to generate profit, mostly in short-term trading. Today, we're going to explain everything you need to know about momentum indicators and how to use them in trading strategies.

 

What are Momentum Indicators?

Momentum indicators are basically trading tools used by traders to measure the speed or rate of change of the price movement. It can be applied in almost all financial markets, but mostly forex and stock due to the high volatility and liquidity.

Momentum indicators are also known to fall under the Oscillator type in technical trading. In addition, momentum indicators are often considered as a leading indicator because they could foretell potential price changes before they happen.

By analyzing the speed of the price changes on the chart, we could estimate the strength or "momentum" of the financial instrument. If the indicator shows that the momentum is accelerating, it means that the trend is strong and likely to continue. On the contrary, if the momentum is waning, it indicates that the market is exhausted and there may be a reversal or retracement coming.

Apart from that, momentum indicators actually have several other use cases for traders, namely as a trend confirmation signal and a trend reversal signal. You can decide which function is more appropriate to use based on the market that you're trading on. For instance, in a trending market, you would want to use the indicator as a confirmation signal, while in a ranging market, you would want to use it as a reversal signal.

Please note that momentum indicators work best if it's combined with other trading tools. So to get a complete insight into the market, you could try combining it with technical indicators such as Moving Average, RSI, and more.

 

Calculating the Momentum

The momentum of the price is pretty easy to measure. Even though the numbers are usually automatically displayed by the charting program, it's still important to understand how the calculation is done.

There are several versions of the formula, but the basic concept is that the momentum (M) is the comparison between the current closing price (CP) and the closing price in "n" periods ago (CPn). The value of "n" is determined by the trader.

M = (CP / CPn) 100

The result of the above calculation will be shown in percentage. The calculation shows when the price is going to move in a certain direction and how strongly. If the percentage is higher than 100, that means the price is above the price "n" periods ago.

If the percentage is lower than 100, it means that the price is below the price "n" periods ago. Moreover, how far the result is above or below 100 shows how fast the price is moving. So for example, a momentum of 96% means that the price is moving down with more force than the momentum of 98%.

 

How to Identify Momentum Indicators Signals

There are three primary methods that you can use to read and catch signals from momentum indicators, such as:

 

1. 100 Cross Line

This method is one of the options that many traders use. The idea is pretty simple: when the price moves from below the 100 line and breaks through it to the upside, then it signals that the price is moving higher. Thus, you would want to trade from the bullish side.

In contrast, when the price moves from above the 100 line and crosses it to the downside, it signals that the price is dropping and you would want to trade on the bearish side.

One thing to keep in mind is that the 100 line cross method is prone to "whipsaws", which means that the price might cross the 100 line but then move back to the opposite direction almost immediately. For this reason, it's crucial to pay attention to where the price is in relation to the 100 line and use other filters to determine the best entry spot.

For example, if the asset is in an uptrend, wait until the price pulls back from the 100 line after the cross happens. Additionally, you could use reversal candlestick patterns to further confirm the signal as shown in the example below.

100 cross line

 

2. Crossover Signal

This method requires both momentum indicator and Simple Moving Average (SMA) applied on your chart. You could pick any period or length for the moving average, but the common setting is usually a 10, 14, or 21-period moving average. Once you have both lines displayed on the chart, you just have to wait until the two lines cross each other.

The basic idea is to buy the asset when the momentum line crosses the SMA line from below and sell when the momentum line crosses the SMA line from above.

Similar to the previous method, crossover signals also have the same "whipsaw" issue, which once again can be fixed by moving only on trading signals that goes in the direction of the underlying trend. So if the trend is going downward, open a short trade only after the indicator has moved above the SMA line and then drops below. Close the short trade when the indicator moves above the SMA line.

Alternatively, you can also take signals after the occurrence of an overbought or oversold condition. The following chart shows a crossover signal combined with an RSI reading.

Crossover signal

 

3. Divergence Signal

Divergence basically describes a condition where the price and the momentum indicator are moving in the opposite direction. It can either be a bullish divergence or bearish divergence.

A bullish divergence occurs when the price is going lower, but the momentum indicator is moving higher. This shows that the price is dropping, but the momentum behind the selling is weakening, so it can confirm a buy signal for you.

Meanwhile, a bearish divergence occurs when the price is going higher, but the momentum indicator is going lower. This indicates that the price is rising, but the momentum behind the buying is weakening, so it basically gives you a sell signal.

In a nutshell, the occurrence of divergence indicates that the momentum is fading and that could lead to price retracement or trend reversal. This usually happens at market extremes where prices have moved too far. This is why the divergence method works best in ranging markets. Take a look at the example below.

Divergence momentum

Trending markets tend to have strong momentum, so the probability of getting false signals from divergence analysis is pretty high. Please note that divergence should not be used alone. It is rather used to confirm signals produced from other strategies. Even if the price has moved so far and the divergence signal seems strong enough for a reversal, there's still a chance that it is a false signal and the current trend remains.

 

Momentum Trading Strategies You Can Try

It is worth noting that a momentum trading strategy can either be beneficial in the short-term or long-term trading. Short-term momentum trading is often used in day trading, while long-term momentum trading is usually used in position trading. The following are some trading strategies that make use of the market momentum.

 

1. Momentum Divergence Strategy with Zig Zag Pattern

As the name suggests, the strategy combines momentum indicator, divergence signal, and the use of zig-zag pattern. Since we already spoke about divergence in the previous section, let's learn about the zig-zag pattern.

The zig-zag pattern that we talk about here refers to the simple pattern that was first introduced in the Elliott Wave theory. The pattern basically consists of three waves, namely A, B, and C. Take a look at an illustration below.

The zig zag pattern

Wave A is the first wave of the pattern and it is followed by Wave B, which is a retracement of the trend. Therefore, Wave B's movement is smaller than Wave A. The final wave is called Wave C. It moves in the same direction as Wave A and must extend beyond it as well.

Now all you need to do is look out for the occurrence of the three elements of the strategy:

  1. The overall trending market
  2. A zig-zag pattern within that trending market
  3. A divergence formation occurs within the zig-zag pattern. Here, the divergence signal is used as a confirmation for the zig-zag pattern on the chart.

Once you fulfill all the requirements, it's time to figure out the entry spot. The entry signal is shown on the break of the trend line that extends from the start of Wave A and connects to the start of Wave C. This is usually known as the A-C trend line. To minimize the risk, place a stop loss beyond the most recent swing made before the A-C trend line breakout. As for the profit target, place it inside the start of Wave A.

Example of the zig zag strategy

From the chart above, we can see that the market has an overall steady downtrend. Then, at some point, the price forms a zig-zag pattern that we're looking for. At the same time, there's a bulling divergence forming within the pattern as shown in the dashed grey line. All of these elements refer to a possibility of a reversal, so we should be ready for a long trade.

In that case, we need to wait until the price breaks and close beyond the A-C trend line. This is the entry signal that we need, so open a long trade at this level, then place the stop loss below the previous swing low. Lastly, exit the trade when the price moves and reaches the start of the zig-zag pattern.

 

2. Momentum Support and Resistance Strategy

The next strategy that we're going to talk about is regarding Support and Resistance levels. Both concepts are actually pretty common in technical trading, but in case you didn't know already, Support refers to the area where the price is likely to find demand (buying pressure), whereas Resistance is the area where the price is likely to find supply (selling pressure).

If the price breaks through a Support level, the Support will turn into a new Resistance and vice versa. Keep in mind that Support and Resistance levels are usually perceived as an area instead of a single line or level.

In this strategy, you need to combine the momentum indicator with divergence signals once again, but this time you're going to trade the divergence off of a key higher time frame level. This is important because typically, traders only focus on one time frame and lose sight of the bigger picture. Therefore, using the Support and Resistance levels from a higher time frame will give you a better understanding of the overall market condition.

If you're trading on a 60-minute chart, your key levels would be taken from the next higher time frame, which is the 240-minute chart. Similarly, if you're trading on a 240-minute chart, your key levels would be taken from the daily chart, and so on.

To start with, you need to wait for the price to move closer to the key Support or Resistance levels that are already plotted on the chart. Then, look for a divergence pattern that occurs near the Support or Resistance level. Once the divergence confirms the signal, then it's safe to use the area as your trade setup.

Now you can enter the trade when there's a momentum indicator crossover and exit the trade when there's another crossover in the opposite direction. Don't forget to set a stop loss at the most recent swing prior to the momentum crossover signal.

 

Conclusion: Is Momentum Trading Strategy Worth It?

Momentum trading is a quite popular trading strategy, especially in stock and forex markets. The strategy basically identifies the best opportunities to enter the market according to the trend strength. This can give an incredible advantage whether you're following the trend or trading against the trend. How so? If you're a trend trader, knowing when the momentum is strong would give a valid confirmation to ride the trend as it is a good indication that the trend can carry on. Otherwise, weak momentum is a signal to avoid the market. The opposite trick can be applied by reversal traders since they like to profit from the change of price trend; weakening momentum is when they prepare to enter the market and vice versa.

If you're able to utilize momentum indicators and apply the signals during appropriate market conditions, momentum trading could definitely give you generous returns both for short-term and long-term trading.

However, keep in mind that false signals happen all the time and momentums don't last forever. Therefore, there's no guarantee that your plan will always go smoothly. At the end of the day, we can conclude that momentum trading is risky, so do not go overboard and make sure to practice the strategies first on a demo account.