Momentum indicators are technical analysis tools that help traders measure the direction and speed of changes in price. They give an insight into the technical strength or the weakness of assets. Momentum indicators are more useful and accurate than most Forex analytical tools, but it is important to understand how to best use them and in which market conditions they tend to work best.
Read on to learn how to use momentum indicators as part of a profitable Forex trading strategy.
What are Momentum Indicators?
- The concept of momentum is simple – in what direction is the price moving, and how quickly?
Momentum indicators are algorithms applied to historical prices which measure the direction and speed of price changes over a given period.
- Momentum indicators provide traders with crucial information about the strength or weakness of an asset.
- Momentum indicators are essential tools for trend traders but can also be used to help spot trend reversals, or to adjust stop loss and take profit orders.
A look at the best momentum indicators:
Relative Strength Index (RSI)
- The RSI indicator measures the ratio between upward and downward price movements over the look back period.
- The RSI indicator always produces a value between 0 and 100, but the extreme points are almost never touched. A reading of 100 represents the fastest upwards momentum, while 0 the fastest downward momentum.
- The most basic use of the RSI is to indicate bullish conditions when the reading is above 50, or bearish conditions when the reading is below 50.
- A reading below 30 may indicate oversold conditions, and a cross from below 30 is often used as a long trade entry signal.
- A reading above 70 may indicate overbought conditions, and a cross from above 70 is often used as a short trade entry signal.
- More reliable trading signals occur when a positive divergence forms below 30 or a negative divergence above 70 (more later about divergence).
- RSI crosses can be confirmed as signals by an increase in volume, if a reliable volume indicator is available – Forex traders tend to use tick volume, while futures traders may access real volume data.
Moving Average Convergence Divergence (MACD)
- The MACD indicator measures the relationship between two exponential moving averages (EMAs) over the look back period, the 26 EMA and the 12 EMA. The 26 EMA is subtracted from the 12 EMA in default settings, which can be changed. The difference between the two EMAs is represented by the MACD histogram which crosses the MACD line at zero.
- The MACD signal line is a 9 EMA in default settings.
- A crossover of the MACD signal line above the MACD line is a buy signal and is widely regarded as more powerful if also showing positive divergence and an increase in volume.
- A crossover of the MACD signal line below the MACD line is a sell signal and is widely regarded as more powerful if also showing negative divergence and an increase in volume.
- Some traders also trade histogram crossovers, buying when the histogram crosses above the MACD line, or selling when it crosses below it.
- The Stochastic Oscillator compares the current price to the range of closing prices over the look back period, and prints two lines, the value of the indicator and an average of its recent values.
- Like the RSI indicator, its value ranges from 0 to 100, from most bearish to most bullish. A value below 20 can indicate oversold conditions, while a value above 80 can indicate overbought conditions.
- The cross of the stochastic fast line over the slower average line is the basic signal, but most traders want to see this combined with another signal such as:
- Both lines crossing up above 20, with fast line crossing above average line, for a buy signal; or
- Both lines crossing down below 80, with fast line crossing below average line, for a sell signal.
- Divergences between the indicator and the price action are regarded as especially powerful signals, when they coincide with the typical indicator-only signals detailed above.
Rate of Change (ROC)
- This is a very simple indicator. It measures the percentage change in price over a defined look back period.
- The ROC momentum indicator measures the speed at which prices change.
- A positive ROC indicates a potential buy, while a negative ROC indicates a potential sell.
- Crosses from negative ROC to positive ROC can be seen as buy signals, and vice versa regarding sell signals.
- Traders should also look for divergence upon seeing an indicator crossover above or below the zero line for especially powerful signals.
Average Directional Index (ADX)
- The Average Directional Index (ADX) indicator calculates a moving average of changes in the price range over the look back period. The ADX rises when the values of the Plus (+DI) and Minus Directional Lines (-DI) diverge and falls when their values converge.
- The ADX measures the strength of trend/momentum, not its direction.
- An ADX value of 20 or higher is seen as indicating a trend is present, with strong trends registering AD values of 30 or higher.
- Traders should look for buy signals when +DI is higher than -DI plus the ADX is above 20, and vice versa for sell signals.
Using Momentum Indicators to Generate Trade Signals
There are basically three ways to read a momentum indicator to generate trade entry signals:
Enter long if indicator is showing a positive value or short if indicator is showing a negative value (for example, if the RSI is above or below 50). This will always align your trading with the dominant momentum of the look back period the indicator is set to. However, this is a crude method and will generate too many signals, so should be used only sparingly, possible as confirmation of a signal given by another type of indicator or analysis method.
Crossovers: go long when the indicator crosses back above the oversold level, or short when the indicator crosses back below the overbought level. These are more powerful and rarer signals, especially when the indicator is showing divergence from the price action.
Multiple Time Frame Analysis: for example, the indicator on a higher time frame chart shows bullish momentum, while the same indicator on a shorter time frame shows bearish momentum just starting to turn bullish. These can be the most powerful and effective signals of all, as they give you entries within dips in trends.
The Importance of Divergences in Momentum Indicators
Momentum indicators create plenty of trading signals, especially on shorter time frames, but even the best momentum indicator creates an abundance of false signals leading to losing trades. Taking only those signals which also show a divergence can filter out noise and deliver a better win rate.
When is divergence and when does it occur?
- A positive divergence appears when price action moves lower, while the momentum indicator moves higher, and the accuracy increases if it happens in oversold territory, supported by higher volume and a wider bullish chart pattern.
- A negative divergence appears when price action moves higher, while the momentum indicator moves lower, and the accuracy increases if it happens in overbought territory, supported by higher volume and a wider bearish chart pattern
For example, a bullish divergence is shown in the price chart below. The indicator in the lower panel showing a higher low, while the price action on the chart is showing a lower low at the same time. In these cases, the indicator is effectively leading and so may be showing the next price movement is likely to be upwards, which is not indicated by the price action. The indicator was correct in this case, accurately forecasting a significant price rise.
Example of Accurate RSI Divergence in USD/JPY Price Chart
- Momentum indicators can offer more reliable trading signals when used together with volume or volatility indicators, plus candlestick or Forex chart patterns.
The Advantages and Disadvantages of Momentum Indicators
What are the advantages of momentum indicators?
Trading with strong momentum provides a proven edge in liquid speculative markets such as Forex. Momentum indicators can help highlight the times when this edge is present in the market.
- Momentum indicators can allow traders to spot potential market reversals, most reliably via divergences and in conjunction with a volume increase.
- They can also confirm the existence of a trend and measure its strength.
- Traders can use momentum indicators for stop loss and take profit adjustments.
- They are ideal as part of automated trading solutions.
- Momentum indicators can be used to confirm candlestick / chart patterns.
What are the disadvantages of momentum indicators?
- Momentum indicators require other indicators, ideally volume or volatility, to generate more accurate trading signals.
- They only provide a standalone edge on higher time frames in the Forex market.
- They are also more reliable when used in conjunction with chart and candlestick pattern recognition.
How to Apply Momentum Indicators
The best way to apply momentum indicators to your Forex trading is to put them on a higher timeframe chart and look for Forex pairs that are showing strong directional momentum. When you find a suitable pair, drop down to lower time frames to find precise entries: you can use the same indicator.
Of course, momentum indicators can be used in many combinations and styles, as in the example below.
- Analyze the D1 chart to scan for chart patterns, filtering assets showing bullish or bearish ones, ignoring the rest.
- Confirming the existence of bullish and bearish trends in the D1 chart patterns using the ADX indicator and discarding any with a value below 30.
- Looking for oversold and overbought conditions on H4 charts where the D1 chart showed a strong trend, with the Stochastic Oscillator.
- Using the RSI on the H1 chart to find positive or negative divergences and spot entry opportunities confirmed by an additional volume indicator (in Forex, volume data from the relevant currency futures can be used, or tick volume data, or proprietary volume data provided by a Forex broker).
Relying too heavily upon indicators in Forex trading is a major mistake made by many new traders. However, momentum is probably the most widely studied technical aspect of speculative markets like Forex, and it has been shown in many academic studies to provide a statistical edge in predicting future price movements. Basically, if the price of EUR/USD or USD/JPY is breaking to new long-term highs or lows with unusually strong momentum, it is more likely to continue than reverse, and this edge can be used to generate profits. Momentum indicators can help you exploit this edge with precision.
Momentum indicators are especially reliable if used as primary signals only on higher time frames, and when confirmed by other tools such as other types of indicators, breakouts, or chart / candlestick patterns.
Signals showing divergence between the indicator and the price action on the chart also show abnormally high level of accuracy.
The worst thing you can do with any indicator is set it up on a range of assets on a short time frame price chart and take every trade indicated on many assets. This will certainly lead to net losses – you need to be discerning and aim for trading only the higher-quality signals that you see. Practice will teach you the typical signs showing which signals will tend to be the most reliable.
How do you interpret momentum indicators?
Momentum indicators offer traders information about the speed of price changes, can confirm chart patterns, identify oversold and overbought conditions, and hint at trend reversals.
What is the best technical indicator for momentum?
The RSI and the ADX have the best track records of all momentum indicators at correctly indicating likely future price movements.
Are momentum indicators leading indicators?
Momentum indicators are generally regarded as lagging indicators, although some analysts argue that the ADX is a leading indicator.
Are stock momentum indicators identical to Forex momentum indicators?
Since momentum indicators rely on historical prices to calculate their output, they are identical for all assets. Traders can fine-tune settings based on sectors or individual trading instruments, but the functionality of momentum indicators does not vary between stocks, Forex, or any other asset class.
What is the Squeeze Momentum Indicator?
- The Squeeze Momentum Indicator combines Bollinger Bands, which measure volatility by using standard deviations, with the Keltner Channel, which measures the Average True Range (ATR).
- Traders look for the Bollinger Band to move outside the ATR indicated by the Keltner Channel, which suggests an increase in momentum.
- The Squeeze Momentum Indicator uses black dots to indicate no trading signal, red dots for sell signals, and green dots for buy signals.
- A crossover from red to green or from green to red suggests a momentum change and tends to offer the most reliable signal.