How do momentum indicators work?

A momentum indicator is nothing more than a visual representation of a comparison between the current price of an asset and the prior price. How far into the past we make the comparison is a decision made by the technical analyst, and there are reasons to make shorter and longer term comparisons. Calculating a simple momentum indicator is also simple: Current price minus the price n-periods ago (where n is the number of periods selected by the analyst). Using that simple equation we get a momentum indicator that is positive when price is rising and negative when price is falling. It is displayed as an oscillator with values either from 0 to 100 or from -50 to +50, depending on the analyst’s preference. Using the momentum indicator is also fairly simple although it is best to use them with another indicator to confirm price action.

Buy Signal

The indicator generates a buy signal when the oscillator crosses the midpoint to the upside, indicating price is reversing course after hitting a bottom, or increasing momentum as it breaks out to new highs.

Sell Signal

The indicator generates a sell signal when the oscillator crosses the midpoint to the downside, indicating price has either hit a top or has broken to new lows.

Momentum Exit Signals

Using the buy and sell signals as an exit signal for existing trades is not a good strategy. That is because when the momentum indicator has had time to return to the midpoint nearly all the profits have almost certainly disappeared. In the worst case not only have the profits gone, but the trader has allowed a winning trade to turn into a losing one. As soon as the momentum line turns back towards the midpoint of the oscillator, it means the trader is losing profits. So, the trader must know how far back the indicator can travel before it triggers an exit. One strategy trader’s use for exits is to draw a trend-line on the momentum indicator and a break of that trend-line is an exit signal.

Momentum Divergences

Another potential use for momentum indicators is in identifying divergences between the indicator and the actual price action. There are both bullish and bearish divergences to watch for, and while this article is too short to go into details, these divergences are often good exit signals themselves. However, a divergence by itself isn’t always a reason to exit a position. Divergences can be thought of as warnings of a potential reversal on the way. When a trader notes a divergence they should become more aware of price action, and can look for confirming signals of a price reversal from other indicators.