Momentum Indicators

To measure the rate at which the price fluctuates.

Author: Adin Lykken
Adin Lykken
Adin Lykken
Consulting | Private Equity

Currently, Adin is an associate at Berkshire Partners, an $16B middle-market private equity fund. Prior to joining Berkshire Partners, Adin worked for just over three years at The Boston Consulting Group as an associate and consultant and previously interned for the Federal Reserve Board and the U.S. Senate.

Adin graduated from Yale University, Magna Cum Claude, with a Bachelor of Arts Degree in Economics.

Reviewed By: Matthew Retzloff
Matthew Retzloff
Matthew Retzloff
Investment Banking | Corporate Development

Matthew started his finance career working as an investment banking analyst for Falcon Capital Partners, a healthcare IT boutique, before moving on to work for Raymond James Financial, Inc in their specialty finance coverage group in Atlanta. Matthew then started in a role in corporate development at Babcock & Wilcox before moving to a corporate development associate role with Caesars Entertainment Corporation where he currently is. Matthew provides support to Caesars' M&A processes including evaluating inbound teasers/CIMs to identify possible acquisition targets, due diligence, constructing financial models, corporate valuation, and interacting with potential acquisition targets.

Matthew has a Bachelor of Science in Accounting and Business Administration and a Bachelor of Arts in German from University of North Carolina.

Last Updated:December 18, 2023

What are Momentum Indicators?

A handy tool used in technical analysis to determine the momentum and price fluctuation of the stock, currency, and commodity market. Traders use momentum indicators to measure the rate at which the price fluctuates.

Through this indicator, traders can predict if it is going high or low. Likewise, the rise and fall in the prices can be projected. These indicators work best when the market is going upward rather than when it's going downward.

When momentum indicators are combined with other hands, they work best to identify the time frame of the market's fluctuations and not the moment's direction.

The momentum indicator combines two words, ' momentum' and 'indicator.' Momentum is the velocity or the speed of the rise and fall of stock prices. It is used to determine the fluctuation in prices.

Momentum is generally considered to have two types: upward and downward. On the upside, the prices started rising and showing growth; on the other hand, the low reflected the fall in stock prices.

Indicators are primarily used in the technical analysis of different securities traded. They are mathematical calculations based on a security's price and volume. They are generally used to predict the future costs of assets.

So, Momentum Indicators are mathematical calculations based on the fluctuations of asset prices and tell us whether it is going up or down. It helps the trader to predict future prices.

It helps the trader to understand the rate or speed from which the prices of a security change in the trading market and the frequency of the fluctuation of the fees.

Momentum = (Current Closing Price/ Previous Closing Price) * 100

So, ultimately it is all about movement in the market value of the securities that momentum indicators show us and help to determine the future returns and evaluate the risk involved.

In the different types of the securities market, which include currency, commodities, and the stock market, there is another concept of momentum known as Divergence.

Now the question arises: what is Divergence? 

Understanding Divergence

Divergence indicates that the momentum of the market price movement is stalling or will reverse. It arises when a momentum indicator continuously falls with the market price but rotates upward, indicating a future rise in value.

It means that when the indicator falls with the market prices (falls), sometimes the arrows rotate and start going upward, but the price is still decreasing, which signifies that the indicators have stopped tracking the price movement.

It is a clear signal that the momentum of the asset's market value is decreasing, which means the rate of change in the downward movement of pricing is dropping at a decreasing rate.

If the market price and momentum start diverging in an upward direction, then it is a bullish divergence. On the other hand, if they start dividing themselves at the downtrend slope, it is a bearish divergence.

Popular Momentum Indicators

Many types of indicators show the momentum and fluctuation in the value of the different securities; some of them are explained below:

1. RSI (Relative Strength Index)

It is one of the most widely known and used MOM indicators by traders analyzing the movement in the change in the market values of the assets, where they check the relative strength of the stocks.

RSI = SMA(U,n)/ SMA(D,n)

Many traders use it to check the security's strength and weakness based on the stock's current and historical price over a span, which helps them to evaluate whether the price is overvalued or undervalued.

It is recognized as a momentum oscillator developed by J. Welles Wilder and mentioned for the first time in this book (New Concepts in Technical Trading System) in 1978. It is measured on a scale of 0-100.

2. Rate of Change

From the name, we can easily interpret that it is related to the rate at which the prices of securities change. Therefore, it means that it helps to tell the speed at which the cost of the security changes over time.

It is a mathematical expression that tells the asset's market value changes over a certain period. It is the representation of the price fluctuation of the stock.

Rate of Change = [(Current Value/ Previous Value) - 1] * 100

It helps to determine the bullish and bearish Divergence and lets people know when to enter and exit through the stock charts and fundamental technical analysis. High momentum has a positive rate of change and vice-versa.

3. Moving Averages

Moving Average is a type of indicator often used by rookie and pro traders while conducting technical analysis of the stock in financial markets. It shows the moving average value of equity over a while.

It is an indicator that is the calculation to analyze data points by creating a series of averages of different subsets of the complete data set. It means it is used to find average movement.

The formula of the MA is the number of prices within a period divided by the number of total periods. MA can have various period days and weeks, like 52-week MA, 14 days MA, etc.

4. ADX (Average Directional Movement)

It is one of the indicators used to study the momentum of stocks. It is used to primarily identify the strength of a trend and determine when it will stay or go in the opposite direction.

Generally, there are two types of trends which are uptrend and downtrend. An Uptrend means a direction going upwards, indicating that the price will increase in the future.

On the other hand, the downtrend is going downward, indicating the market value will decrease. Both are known as Positive Directional Indicators and Negative Directional Indicators, respectively.

This measure also helps the users assess the momentum and price movements.

ADX = Sum 14 periods of DX/ 14

ADX = [(Prior ADX * 13) + Current DX]/ 14

The indicator was discovered by J. Welles Wilder, Jr to do technical analysis in the financial market. It is measured on a scale of 0-100, where 0-25 is the worst and 75-100 is considered the best.

5. Stochastic Oscillators

A stochastic oscillator is a momentum indicator for comparing the current closing price of the security over a while. George Lane developed it in the late 1950s.

The term stochastic refers to the point of a current price concerning its price range over a while. This method attempts to predict price turning points by comparing the closing price of a security to its price range.

Stochastic Oscillators = [(C - L14)/ (H14 - L14)] * 100

In formula C the current closing price of the stock, H14 is the highest price in 14 trading sessions, and L14 is the lowest price traded in 14 trading sessions, and 100 is a number.

The primary purpose of this indicator is to determine if the securities are oversold or overbought, just like the RSI wish is based on this and ultimately helps in deciding the right buying and selling points for the traders.

How to use Momentum Indicators 

After we talk about the indicators, the question arises of how to use these indicators and how to benefit from these indicators while trading or investing in the equity market.

Knowing how to use these indicators is essential to learn to earn money from them; otherwise, you may lose a lot. There are ways to use these indicators in favor of us and profit from it.

These ways to use indicators are given below:-

1. RSI

We can use RSI to determine the relative strength of the stock we will invest in. In addition, it will help us to determine the fluctuation in stock prices and the speed of changing prices.

The RSI is measured on a scale of 0-100, where 0-30 is not considered the oversold chance of short, where 30-60 is considered good to enter the market, and 75+ is considered overbought and not suitable for entry.

You also have to consider the market's RSI and the sector's RSI because if the whole industry is above 60, then it is not a good time to buy, and if the stock or the entire industry is above 75, then it's time to sell the shares.

2. Rate of Change

It helps you to tell the fluctuation in the prices of the assets and the volatility of the stock and to determine the average dip and average gain over a while.

It helps in the risk allocation and tells you how risk is involved so that you can decide if you can take the risk and, if yes, what will be your average profit or loss by determining the speed of change.

It is a good tool for evaluating the price momentum of the stock in the market.

3. Moving Average

It is one of the most commonly used tools for studying the stock's momentum and doing Momentum analysis. In addition, it helps us to determine the average moving change in a store.

This will help you to know how the stock is moving over a certain period, whether it can be 52 weeks MA, 26 weeks MA, 14 days MA, or 90 days MA, which will help to determine the supposed return for the time being.

Traders generally use it to know the possible return from the stock over a while. For example, suppose, A store gives a 10% return in 52 weeks MA; then the trader believes that this can be his return for that much time.

These are not tips and tricks for investing; this is for educational purposes only. Invest after analyzing the stock personally or after the advice of an investment adviser and consultant.

4. ADX

ADX helps you to know the trend, which is one of the most important things while doing a technical analysis of the stock and one of the prime indicators for analyzing momentum.

It helps to determine whether the stock is in an uptrend or downtrend, which will tell you that if the store is in an uptrend, then the value is going up, which is an excellent sign to enter the market and earn a return.

But if the trend is downward, the value goes down, which is not a good time to enter but an excellent time to sell. It means ADX plays a vital role in trading.

5. Stochastic Oscillators

Stochastic oscillators are one of the oldest and most traditional indicators for seeing the momentum of the share. George Lane discovered it in the 1950s. But, first, it helps to know the volume of assets.

It shows if the stock is oversold or overbought. Well, it means that if stock is overly sold, people are trying to sell the share, and not interested in buying the stock means there is an excellent chance to enter.

If the stock is overly bought, which means people are buying much more than the available supply of it, it means most of the people have already earned profit and are going to book it very soon, so it is right to exit.

Ultimately it means that it shows the buying and selling points to the traders to book their gains and put their money according to the level mentioned above.

It assesses the momentum as well as the speed of the market. But unfortunately, it does not consider the volume and the price.

Limitations of Momentum Indicators

After knowing about momentum, divergence, indicators, and how to use them. Then a question arises that is there any disadvantages of this the answer is yes, and some of them are as follows:

1. These indicators are usually inconsistent and unpredictable

It means these tools generally depend on the fluctuation of prices and movement of prices which is highly influenced by demand and supply.

As an individual or a company, it is difficult to predict the demand and supply levels every time. We cannot interpret the demand and supply graph of a single stock or a group of stocks.

To analyze demand and supply, you need the volume of purchasing and selling of the share, which is not easy to find for a big corporate company, but supposes if you can find it, then you will also have a window of a few seconds.

Within the window of a few seconds, it is nearly impossible to place an order and get confirmation and execute the order by the brokers. So, that's why it is challenging to be consistent and predictable. 

2. It does not consider the financial statement and condition of the company

For example, in technical analysis, while using these tools, the trader does not consider the company's balance sheet and income statement.

By not looking or not considering them, we underestimate the power of fundamental analysis or the ability to profit, which is terrible because if the company you are investing in has a colossal loss, sooner or later, the price will fall sooner or later.

As it is the basis of doing business, profit is essential for the industry. If losses occur in the business for a long time, investing in such a company is harmful or may fail to bankrupt and shut down.

It tells you that a company's financial position is terrible. Then if the momentum is good, eventually, it will fall because of inadequate financial reports, and there are many examples of that as profit is the heart of the business.

3. It does not consider the fundamentals of the business

It means they do not consider the fundamentals, which include turnover (Sales), EBITDA, management, promoter's shareholding, management, and industry.

They all play an essential role in the growth of the organization, and if the organization is more, then only the stock price will grow high, and then you will see the upward momentum to enter or visa-versa.

And ultimately, if the turnover increases, the revenue increases, increasing profits. Conversely, if the turnover decreases, yield decreases, resulting in price decreases and a downtrend for the stock.

So, you also have to consider these factors while trading in the financial market.

Momentum Indicators FAQs

Researched and authored by Kartikay Agarwal | Linkedin

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources: