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What are momentum indicators?

Momentum is a concept used in technical analysis to describe the rate of change of an asset’s price.

It tells the trader how fast or how slowly the asset price is going up or down.

A whole class of technical indicators has been created to measure momentum.

Why are they called momentum indicators?

A momentum indicator works by calculating the rate at which the price of a financial asset is changing. Therefore, momentum indicators can measure how strong or weak a market trend is.

Once a price’s rate of price change starts to slow down, this is a signal that the trend is nearing exhaustion. This is usually the first sign of an impending reversal.

In contrast, when momentum shows that there is an uptick in the rate of price change of an asset, it is a sign that the trend is picking up steam.

From the definitions above, a momentum indicator can be used to spot reversals, and can also spot breakouts from a range and the ensuing trend continuation (i.e. the breakout trades). We’ll come back to those later.
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Oscillators: the MT4/MT5 momentum indicator class


A momentum indicator measures the rate at which the price of an asset changes. If you are familiar with the ThinkMarkets MT4 or MT5 platform, you can view the oscillators or momentum indicators by clicking the Insert tab, then right-clicking on ‘Indicators’ on the drop-down menu and finally, right-clicking ‘oscillators’.

This displays the 13 momentum indicators shown on the MT4 platform. There will be more on this later in this article, but at this point we would recommend you open a demo account so that you can see what we are referring to ‘in real life’.

Momentum indicators are also called oscillators because they all have a signal line which tends to move from one vertical extreme to the other. As price moves, the signal line ‘oscillates’ from one price extreme to the other. The price extreme areas on the oscillator windows are known as the overbought and the oversold price areas.

Typically, all oscillators have a vertical range. The best momentum indicator setups have definable vertical ranges with a midline/centreline and price extreme areas (overbought and oversold areas).


Commodity channel index


Other vertical ranges are as follows:
  • DeMarker indicator: 0.0 to 1.0, where 0.0 is the most oversold reading and 0.1 is the most overbought reading. Oversold readings start from 0.0 to 0.3, while overbought readings start from 0.7 to 1.0.
 
  • Commodity Channel Index (CCI): On MT4, the CCI has a vertical range of -268.0 to +268.0, where -268.0 is the most oversold reading and +268.00 is the most overbought reading. Oversold readings start from -268 to -100, while overbought readings start from 100.0 to +268.0. On many platforms, -100 to +100 is used as the typical vertical range for the CCI.
 
  • Relative Strength Index (RSI): The RSI has a vertical range of 0.0 to 100.0, where 0.0 is the most oversold reading and 100.0 is the most overbought reading. Oversold readings start from 0.0 to 30.0, while overbought readings start from 70.0 to 100.0.
 
  • Williams Percent Range (Williams %R): -100 to 0.0, where -100.0 is the most oversold reading and 0.0 is the most overbought reading. Oversold readings start from -100.0 to -80, while overbought readings start from -20 to 0.

Some momentum indicators do not have exact vertical ranges. Determining overbought and oversold levels are subjective questions, which makes them unsuitable for use in stock momentum indicator studies.

How momentum indicators are arranged on your platform


It is not very important to know how to manually calculate the various momentum indicators. What is important is to know the best momentum indicator to use in certain setups.

Once you have your MT4 or MT5 setup, simply click on Insert -> Indicators -> Oscillators.

Momentum indicators (oscillators) on MT4

 This will reveal all the oscillators found on the MT4.

You will notice that the MT5 has two additional momentum indicators added:

Momentum Indicator (oscillator setup) for MT5
 

Use of momentum indicator signals in trending markets

Momentum indicators are leading indicators. This means that they can indicate the direction of the market before this manifests in the price. For this reason, they can be used in trending markets to predict a price move before it actually happens.

There are two types of trending markets.

An uptrend is formed by higher highs and higher lows. A downtrend is formed when the price forms lower highs and lower lows. For this discussion,we’ll treat the sideways markets (range-bound or consolidating markets) separately.

So how can you squeeze momentum indicator profits in trending markets? There are two ways to do this.
  • Reversal of a trend using the divergence signal
  • Detection of reversal points at price extreme areas.

 Here are the possible oscillator trade setups.

1. Divergence signals

Divergence is a situation where a line that connects the most recent peaks of the signal line of the momentum indicator faces downwards, while a similar line which connects the price peaks faces upwards. In this case, the momentum indicator is leading the price, which is expected to correct itself to the downside. This is a bearish divergence setup.

Also, a divergence exists when a line which connects the two most recent troughs of the signal line of the oscillator points upwards, while a similar line which connects the most recent troughs of price faces downwards. Again, price is expected to correct the divergence by moving higher so that its troughs can align with those of the indicator.

Experience has shown that this is one of the best momentum indicator signals you can ever use on any time frame. However, a trader still needs an entry signal (usually a candlestick signal) to enter into the trade based on the divergence signal.

Divergence sell signal

This is an example of how price corrected a bearish divergence on the weekly chart of BoA. Here, the perfect stock momentum indicator used was the commodity channel index (CCI). You can also use the momentum indicator and the DeMarker oscillator. These three are the best momentum indicators when it comes to divergence signal trading.

The entry signal was the hammer and the bearish candle follow-up. A short trade is used. In exiting a sell trade from a bearish divergence, it is a good idea to use previous support, or a resistance-turned-support (as shown above) level as a guide.

You can use similar setups (but in reverse) to detect a bullish divergence scenario.

Divergence buy signal

From the sell trade example provided previously, can you spot the divergence and entry/exit areas on the snapshot above?



2. Price Extreme Signal

In trending markets, price extremes (overbought/oversold market conditions) can be used to detect price reversal points. However, many traders get this signal all wrong. Even the best momentum indicator signals using price extremes must be interpreted correctly otherwise the entire trade setup would go to pieces.

One thing every trader must know is that the signal line of a momentum indicator can stay in a price extreme area for a long time, and while this is going on, the price may continue to trade higher in an uptrend or lower in a downtrend. Setting a reversal trade prematurely in these circumstances would fail.

Rather, the trader should deploy what is known as a ‘failure swing’ setup. This is a setup in an uptrend, where two successively lower peaks are formed by the indicator’s signal line in the overbought extreme area. Also, this setup forms where two successively higher troughs form in the oversold area. The best momentum indicator for this is the relative strength index (RSI).

Here is how to detect and use this setup to squeeze momentum indicator reversals in trending markets.

Failure swing setup in the overbought region

 You will notice one thing on the indicator window: the signal line stayed in the overbought area for some time. Right before the ‘failure swing’, the indicator spent close to three weeks in the overbought area.

However, two successively lower peaks formed, indicating a failure of the bulls to sustain further uptrend. This signal of price exhaustion eventually played out on the charts as a downward reversal.

A similar setup also occurs in the oversold area. However, the failure swing in the overbought region tends to produce stronger price reversals.

The one shown on this chart produced a $3.51 price move, which could potentially have delivered $351 with a purchase of 100 shares. A live account on an MT4 broker provides access to stock trading where you can replicate these moves using the right strategy.
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Use of oscillators in consolidating markets

Earlier in this article, I mentioned that one of the momentum indicator applications was to detect the acceleration of the rate of change of market price.

This is a factor that can be used in breakout trading, where price resumes in the direction of the previous trend after a consolidation.

However, you may find it interesting to note that the momentum indicators can also be used to trade when markets are in consolidation.

A consolidating market is one in which the price trades within a defined vertical range, marked by a price floor as the support, and the price ceiling as the resistance.

Here is a snapshot of a market in consolidation, and the role of a stock momentum indicator on the price chart of this stock asset:

Stock momentum indicator in a range trade of BoA stocks

This is a weekly chart for Bank of America Merrill Lynch stocks (BoA).

The horizontal lines on the price chart define the range of the price: 31.31 as the price ceiling, and 26.42 as the price floor.

Notice the areas marked off with the brown rings. These are the areas where the signal lines of the stock momentum indicator (Stochastics) crossed at an overbought level.

You can see that the price hit the upper barrier of the range at the same time. This would have been a signal to short the stock.

Also, the areas marked with purple rings show where the oscillator lines crossed at an oversold level. We see that price hit the lower barrier and turned upwards thereafter.

You can also see the few instances where the price either extended below the lower barrier without a corresponding signal from the stock momentum indicator, and where the price did not touch the barriers despite a signal from the oscillator.

Areas showing price consolidation are where you can squeeze momentum indicator overbought/oversold signals for profits using any time frame chart.

Please note that not all oscillators can deliver range-bound trading signals. Only a few offer such opportunities to squeeze momentum indicator profits from the signals generated.
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Conclusion

The momentum indicators or oscillators produce two good trading signals for trending markets, and one signal for trading range-bound markets. These are the divergence setups, the price extreme failure swings ,and the overbought/oversold reversal signals respectively.

Even the best momentum indicator signals fail if they are applied incorrectly.

You must know what the prevailing market conditions are with respect to the market fundamentals, and trade along those lines. In other words, if there is an economic or political situation playing out that has pushed markets to form a sentiment bias, look for technical setups with the momentum indicators that will trade along the lines of bias and not against sentiment.

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