Editor’s note: This is the second installment in a series on technical indicators. The first article explored three trend indicators to help you determine the existence and direction of a trend.
If you remember your high school physics class, you might recall momentum as being a measure of motion, or mass times velocity. In technical analysis, you can view momentum in a similar way—it's a gauge of how quickly a market is moving given certain factors.
Momentum indicators include:
- Relative Strength Index (RSI)
- Rate of change (ROC)
- Commodity channel index (CCI)
- Moving average convergence divergence (MACD)
Momentum indicators are closely related to trend indicators. Although their primary use is to gauge the strength of a trend, momentum indicators can also indicate when a trend has slowed and is possibly ready for a change. So there are a few different ways to interpret momentum indicators, and no single indicator is superior to any of the others; it’s all about personal preference.
Here are a few examples, in no particular order.
Example 1: Gauge Trend Strength Using MACD
Moving average convergence divergence is a technical indicator that's primarily used to find trends, but it can also be used to estimate a trend's momentum. It consists of two lines: a blue “signal” line and a red “indicator” line.
MACD signals a trend when the blue signal line crosses above or below the red indicator line. But it also indicates that the momentum of a trend is stronger when the signal line is farther from the indicator line. Conversely, as it gets closer, the trend is weakening. See figure 1.
But MACD is unique in how it's displayed. Most other momentum indicators are interpreted in relation to extreme levels, such as zero to 100. When the indicator is near either of the extremes, the suggestion is that the underlying issue is nearing overbought or oversold conditions, and the current trend is weakening.
Example 2: Measuring Overbought/Oversold Conditions Using RSI
The Relative Strength Index (RSI) is a momentum indicator that compares the magnitude of a stock's recent gains to the magnitude of its recent losses on a scale from zero to 100. More precisely, RSI measures a security's price relative to its own past performance. It’s calculated by taking the average of the closes of the up bars and dividing them by the average of the closes of the down bars.
In general, an RSI reading above a specific threshold (such as 70 or 80) is considered “overbought” and a reading below a certain threshold, such as 20 or 30, is considered “oversold.” See figure 2.
Here we see the RSI indicator with overbought levels set at 70 or above and oversold levels set at 30 or below. When the indicator gets to those extremes, it’s a sign that the momentum may be slowing, and a reversal could be coming. Extreme levels are sometimes set to 80/20 depending on the trader’s personal preference.
Example 3: Momentum at the Mean Using CCI
Another way to interpret a momentum indicator is by its speed and angle as it crosses the center line. The Commodity Channel Index (CCI) is one such measure.
CCI expresses the variation of a security's price based on its statistical mean. Investors can use CCI to spot excess buying or selling pressure when it crosses above the 100 level or below negative 100, respectively.
Figure 3 shows a chart with the CCI plotted below it. The three red lines are, from top to bottom, labeled +100, 0, and -100. In this example, when the signal line crosses the zero line quickly, with a very steep ascent or descent, the momentum in the security increases in the same direction.
As you can see from these examples, the way momentum indicators gauge momentum can vary. Many momentum indicators can also be used as overbought/oversold indicators, and by extension, even help to clue you in when a change in trend may be about to occur.