Momentum Indicators

Table of Content

Momentum Indicators Overview

Momentrum indicators are technical analysis tools used to determine the strength or weakness of a asset’s price. Momentum measures the rate of the rise or fall of asset prices.


Our Best Chosen Momentum Indicators

The LMD Indicator

Our team at AlgoStorm.com uses our own innovative momentum indicator (It is called: LMD). You can access this indicator as part of your membership of AlgoStorm.

The LMD indicator is a premium momentum oscillator that takes trend, volume, volatility, and momentum into account.

  • It displays a unique momentum measure with better insights than the RSI.
  • It displays the open interest of the asset when it is available.
  • It clearly shows oversold and overbought levels.
  • It has lots of advanced options and extra optional features.
  • It can be used on all time-frames.

LMD Illustration:
LMD Indicator

To access our trading system, indicators, and strategies, join us at:
https://www.patreon.com/algostorm

The VTD Indicator

Our team also uses another momentum-based indicator (it is called: VTD). You can also access this one as part of your membership of AlgoStorm.

The VTD indicator is a premium momentum volume-based oscillator that provides insight into the weakness or the strength of an asset.

It is mainly used to measure market momentum and to affirm trends or to anticipate possible reversals. It does this by effectively comparing the recent market momentum, with the general momentum over a wider frame of reference. It is very powerful for spotting divergences.

VTD Illustration:
VTD Indicator

To access our trading system, indicators, and strategies, join us at:
https://www.patreon.com/algostorm

Note: In case you like to trade with free volume-based indicators, this guide will cover the most notable ones.


Moving Average Convergence Divergence (MACD)

MACD Definition

Moving average convergence divergence (MACD) is a trend-following momentum indicator that shows the relationship between two moving averages of a security’s price.

The MACD is calculated by subtracting the 26-period exponential moving average (EMA) from the 12-period EMA.

The result of that calculation is the MACD line. A nine-day EMA of the MACD called the "signal line" is then plotted on top of the MACD line, which can function as a trigger for buy and sell signals.

Traders may buy the security when the MACD crosses above its signal line and sell—or short—the security when the MACD crosses below the signal line.

Moving average convergence divergence (MACD) indicators can be interpreted in several ways, but the more common methods are crossovers, divergences, and rapid rises/falls.

MACD Illustration:
MACD Indicator

Important Points To Remember:

  • Moving average convergence divergence (MACD) is calculated by subtracting the 26-period exponential moving average (EMA) from the 12-period EMA.
  • MACD triggers technical signals when it crosses above (to buy) or below (to sell) its signal line.
  • The speed of crossovers is also taken as a signal of a market is overbought or oversold.
  • MACD helps investors understand whether the bullish or bearish movement in the price is strengthening or weakening.

Using The MACD

There are two common ways for using the MACD. They are as follows:

  1. Using it as a confirmation trigger when the MACD line crosses its signal line.
  2. Using its histogram for spotting divergences between the MACD and the price.

Limitations Of MACD

One of the main problems with divergence is that it can often signal a possible reversal but then no actual reversal actually happens—it produces a false positive. The other problem is that divergence doesn’t forecast all reversals. In other words, it predicts too many reversals that don’t occur and not enough real price reversals.

"False positive" divergence often occurs when the price of an asset moves sideways, such as in a range or triangle pattern following a trend. A slowdown in the momentum—sideways movement or slow trending movement—of the price will cause the MACD to pull away from its prior extremes and gravitate toward the zero lines even in the absence of a true reversal.


Relative Strength Index (RSI)

RSI Definition

The relative strength index (RSI) is a momentum indicator used in technical analysis that measures the magnitude of recent price changes to evaluate overbought or oversold conditions in the price of a stock or other asset.

The RSI is displayed as an oscillator (a line graph that moves between two extremes) and can have a reading from 0 to 100. The indicator was originally developed by J. Welles Wilder Jr. and introduced in his seminal 1978 book, “New Concepts in Technical Trading Systems.”

Traditional interpretation and usage of the RSI are that values of 70 or above indicate that a security is becoming overbought or overvalued and may be primed for a trend reversal or corrective pullback in price. An RSI reading of 30 or below indicates an oversold or undervalued condition.

RSI Illustration:
RSI Indicator

Important Points To Remember:

  • The relative strength index (RSI) is a popular momentum oscillator developed in 1978.
  • The RSI provides technical traders with signals about bullish and bearish price momentum, and it is often plotted beneath the graph of an asset’s price.
  • An asset is usually considered overbought when the RSI is above 70% and oversold when it is below 30%.

RSI Calculations:

The RSI is computed with a two-part calculation that starts with the following formula:

RS = Average Gain / Average Loss
RSI = 100 - 100 / (1 + RS)

The average gain or loss used in the calculation is the average percentage gain or loss during a look-back period. The formula uses a positive value for the average loss.

Periods with price losses are counted as 0 in the calculations of average gain, and periods when the price increases are counted as 0 for the calculation of average losses.

Using the formulas above, the RSI can be calculated, where the RSI line can then be plotted beneath an asset’s price chart.

The RSI will rise as the number and size of positive closes increase, and it will fall as the number and size of losses increase. The second part of the calculation smooths the result, so the RSI will only near 100 or 0 in a strongly trending market.

Note that the RSI indicator can stay in the overbought region for extended periods while the stock is in an uptrend. The indicator may also remain in oversold territory for a long time when the stock is in a downtrend. This can be confusing for new analysts, but learning to use the indicator within the context of the prevailing trend will clarify these issues.

Using The RSI

The primary trend of the stock or asset is an important tool in making sure the indicator’s readings are properly understood.

Many investors will apply a horizontal trendline between 30% and 70% levels when a strong trend is in place to better identify extremes. Modifying overbought or oversold levels when the price of a stock or asset is in a long-term horizontal channel is usually unnecessary.

A related concept to using overbought or oversold levels appropriate to the trend is to focus on trade signals and techniques that conform to the trend. In other words, using bullish signals when the price is in a bullish trend and bearish signals when a stock is in a bearish trend will help to avoid the many false alarms that the RSI can generate.

Generally, when the RSI surpasses the horizontal 30 reference level, it is a bullish sign, and when it slides below the horizontal 70 reference level, it is a bearish sign. Put another way, one can interpret that RSI values of 70 or above indicate a security is becoming overbought or overvalued and may be primed for a trend reversal or corrective price pullback. An RSI reading of 30 or below indicates an oversold or undervalued condition.

During trends, the RSI readings may fall into a band or range. During an uptrend, the RSI tends to stay above 30 and should frequently hit 70. During a downtrend, it is rare to see the RSI exceed 70, and the indicator frequently hits 30 or below. These guidelines can help determine trend strength and spot potential reversals. For example, if the RSI can’t reach 70 on a number of consecutive price swings during an uptrend, but then drops below 30, the trend has weakened and could be reversing lower.

The opposite is true for a downtrend. If the downtrend is unable to reach 30 or below and then rallies above 70, that downtrend has weakened and could be reversing to the upside. Trend lines and moving averages are helpful tools to include when using the RSI in this way.

RSI Divergences:

Another way to use the RSI is by spotting its divergences.

A bullish divergence occurs when the RSI creates an oversold reading followed by a higher low that matches correspondingly lower lows in the price. This indicates rising bullish momentum, and a break above oversold territory could be used to trigger a new long position.

A bearish divergence occurs when the RSI creates an overbought reading followed by a lower high that matches corresponding higher highs on the price.

RSI Swing Rejections:

Another trading technique examines the RSI’s behavior when it is reemerging from overbought or oversold territory.

This signal is called a bullish "swing rejection” and has four parts:

  • The RSI falls into oversold territory.
  • The RSI crosses back above 30%.
  • The RSI forms another dip without crossing back into oversold territory.
  • The RSI then breaks its most recent high.

Like divergences, there is a bearish version of the swing rejection signal that looks like a mirror image of the bullish version. A bearish swing rejection also has four parts:

  • The RSI rises into overbought territory.
  • The RSI crosses back below 70%.
  • The RSI forms another high without crossing back into overbought territory.
  • The RSI then breaks its most recent low.

Limitations Of RSI

The RSI compares bullish and bearish price momentum and displays the results in an oscillator that can be placed beneath a price chart. Like most technical indicators, its signals are most reliable when they conform to the long-term trend.

True reversal signals are rare and can be difficult to separate from false alarms. A false positive, for example, would be a bullish crossover followed by a sudden decline in a stock. A false negative would be a situation where there is a bearish crossover, yet the stock suddenly accelerated upward.

Since the indicator displays momentum, it can stay overbought or oversold for a long time when an asset has significant momentum in either direction. Therefore, the RSI is most useful in an oscillating market where the asset price is alternating between bullish and bearish movements.


Stochastic Oscillator (Stoch)

Stochastic Definition

A stochastic oscillator is a momentum indicator comparing a particular closing price of a security to a range of its prices over a certain period of time. The sensitivity of the oscillator to market movements is reducible by adjusting that time period or by taking a moving average of the result. It is used to generate overbought and oversold trading signals, utilizing a 0–100 bounded range of values.

The stochastic oscillator was developed in the late 1950s by George Lane. As designed by Lane, the stochastic oscillator presents the location of the closing price of a stock in relation to the high and low range of the price of a stock over a period of time, typically a 14-day period.

Lane, over the course of numerous interviews, has said that the stochastic oscillator does not follow price or volume or anything similar. He indicates that the oscillator follows the speed or momentum of price. Lane also reveals in interviews that, as a rule, the momentum or speed of the price of a stock changes before the price changes itself.

In this way, the stochastic oscillator can be used to foreshadow reversals when the indicator reveals bullish or bearish divergences. This signal is the first, and arguably the most important, trading signal Lane identified.

Important Points To Remember:

  • A stochastic oscillator is a popular technical indicator for generating overbought and oversold signals.
  • It is a popular momentum indicator, first developed in the 1950s.
  • Stochastic oscillators tend to vary around some mean price level, since they rely on an asset’s price history.

Stoch Illustration:
Stoch Indicator

Stochastic Calculation:

/*
C = The most recent closing price.
L14 = The lowest price traded of the 14 previous trading sessions.
H14 = The highest price traded during the same 14-day period.
%K = The current value of the stochastic indicator.
*/
%K = (C - L14 / H14 - L14) * 100

Notably, %K is referred to sometimes as the fast stochastic indicator. The "slow" stochastic indicator is taken as %D = 3 – period moving average of %K.

The general theory serving as the foundation for this indicator is that in a market trending upward, prices will close near the high, and in a market trending downward, prices close near the low. Transaction signals are created when the %K crosses through a three-period moving average, which is called the %D.

The difference between the slow and fast Stochastic Oscillator is the Slow %K incorporates a %K slowing period of 3 that controls the internal smoothing of %K. Setting the smoothing period to 1 is equivalent to plotting the Fast Stochastic Oscillator.

Using The Stochastic Oscillator

The stochastic oscillator is range-bound, meaning it is always between 0 and 100. This makes it a useful indicator of overbought and oversold conditions.

Traditionally, readings over 80 are considered in the overbought range, and readings under 20 are considered oversold. However, these are not always indicative of impending reversal; very strong trends can maintain overbought or oversold conditions for an extended period. Instead, traders should look to changes in the stochastic oscillator for clues about future trend shifts.

Stochastic oscillator charting generally consists of two lines: one reflecting the actual value of the oscillator for each session, and one reflecting its three-day simple moving average. Because price is thought to follow momentum, the intersection of these two lines is considered to be a signal that a reversal may be in the works, as it indicates a large shift in momentum from day to day.

Divergence between the stochastic oscillator and trending price action is also seen as an important reversal signal. For example, when a bearish trend reaches a new lower low, but the oscillator prints a higher low, it may be an indicator that bears are exhausting their momentum and a bullish reversal is brewing.

Limitations Of Stochastic Oscillator

The primary limitation of the stochastic oscillator is that it has been known to produce false signals. This is when a trading signal is generated by the indicator, yet the price does not actually follow through, which can end up as a losing trade. During volatile market conditions, this can happen quite regularly.

One way to help with this is to take the price trend as a filter, where signals are only taken if they are in the same direction as the trend.


Stochastic RSI (StochRSI)

StochRSI Definition

The Stochastic RSI (StochRSI) is an indicator used in technical analysis that ranges between zero and one (or zero and 100 on some charting platforms) and is created by applying the Stochastic oscillator formula to a set of relative strength index (RSI) values rather than to standard price data.

Using RSI values within the Stochastic formula gives traders an idea of whether the current RSI value is overbought or oversold.

The StochRSI oscillator was developed to take advantage of both momentum indicators in order to create a more sensitive indicator that is attuned to a specific security’s historical performance rather than a generalized analysis of price change.

Important Points To Remember:

  • A StochRSI reading above 0.8 is considered overbought, while a reading below 0.2 is considered oversold. On the zero to 100 scale, above 80 is overbought, and below 20 is oversold.
  • Overbought doesn’t necessarily mean the price will reverse lower, just like oversold doesn’t mean the price will reverse higher. Rather the overbought and oversold conditions simply alert traders that the RSI is near the extremes of its recent readings.
  • A reading of zero means the RSI is at its lowest level in 14 periods (or whatever lookback period is chosen). A reading of 1 (or 100) means the RSI is at the highest level in the last 14 periods.
  • Other StochRSI values show where the RSI is relative to a high or low.

StochRSI Illustration:
StochRSI Indicator

Calculating The StochRSI:

/*
RSI = Current RSI reading
min[RSI] = Lowest RSI reading over the last 14 periods (or your chosen period)
max[RSI]=Highest RSI reading over the last 14 periods (or your chosen period)
*/
StochRSI = (RSI - min[RSI]) / (max[RSI] - min[RSI])

Using StochRSI

The StochRSI was developed by Tushar S. Chande and Stanley Kroll and detailed in their book "The New Technical Trader," first published in 1994. While technical indicators already existed to show overbought and oversold levels, the two developed StochRSI to improve sensitivity and generate a greater number of signals than traditional indicators could do.

The StochRSI deems something to be oversold when the value drops below 0.20, meaning the RSI value is trading at the lower end of its predefined range, and that the short-term direction of the underlying security may be nearing a low a possible move higher. Conversely, a reading above 0.80 suggests the RSI may be reaching extreme highs and could be used to signal a pullback in the underlying security.

Along with identifying overbought/oversold conditions, the StochRSI can be used to identify short-term trends by looking at it in the context of an oscillator with a centerline at 0.50. When the StochRSI is above 0.50, the security may be seen as trending higher and vice versa when it’s below 0.50.

The StochRSI should also be used in conjunction with other technical indicators or chart patterns to maximize effectiveness, especially given the high number of signals that it generates.

In addition, non-momentum oscillators like the accumulation distribution line may be particularly helpful because they don’t overlap in terms of functionality and provide insights from a different perspective.

Limitations Of StochRSI

One downside to using the StochRSI is that it tends to be quite volatile, rapidly moving from high to low. Smoothing the StochRSI may help in this regard. Some traders will take a moving average of the StochRSI to reduce the volatility and make the indicator more useful.

For example, a 10-day simple moving average of the StochRSI can produce an indicator that’s much smoother and more stable. Most charting platforms allow for applying one type of indicator to another without any personal calculations required.

Also, the StochRSI is the second derivative of price. In other words, its output is two steps away from the actual price of the asset being analyzed, which means at times it may be out of sync with an asset’s market price in real time.


Average Directional Index (ADX)

ADX Definition

The average directional index (ADX) is a technical analysis indicator used by some traders to determine the strength of a trend.

The trend can be either up or down, and this is shown by two accompanying indicators, the negative directional indicator (-DI) and the positive directional indicator (+DI).

Therefore, the ADX commonly includes three separate lines. These are used to help assess whether a trade should be taken long or short, or if a trade should be taken at all.

Important Points To Remember:

  • Designed by Welles Wilder for commodity daily charts, the ADX is now used in several markets by technical traders to judge the strength of a trend.
  • The ADX makes use of a positive (+DI) and negative (-DI) directional indicator in addition to the trendline.
  • The trend has strength when ADX is above 25; the trend is weak or the price is trendless when ADX is below 20, according to Wilder.
  • Non-trending doesn’t mean the price isn’t moving. It may not be, but the price could also be making a trend change or is too volatile for a clear direction to be present.

ADX Illustration:
ADX Indicator

Calculating The ADX:

/*
ATR = Average True Range
CDM = Current DM
-DM = Previous Low - Current Low
+DM = Current High (CH) - Previous High (PH)
+DI = (Smoothed +DM / ATR) × 100
*/
Plus_DI = (Smoothed +DM / ATR) * 100
Minus_DI = (Smoothed -DM / ATR) * 100
DX = |Plus_DI - Minus_DI| / |Plus_DI + Minus_DI| * 100
ADX = (Previous DX * 13 + Current DX) / 14

Using The ADX?

The ADX, negative directional indicator (-DI), and positive directional indicator (+DI) are momentum indicators. The ADX helps investors determine trend strength, while -DI and +DI help determine trend direction.

The ADX identifies a strong trend when the ADX is over 25 and a weak trend when the ADX is below 20. Crossovers of the -DI and +DI lines can be used to generate trade signals. For example, if the +DI line crosses above the -DI line and the ADX is above 20, or ideally above 25, then that is a potential signal to buy. On the other hand, if the -DI crosses above the +DI, and the ADX is above 20 or 25, then that is an opportunity to enter a potential short trade.

Crosses can also be used to exit current trades. For example, if long, exit when the -DI crosses above the +DI. Meanwhile, when the ADX is below 20 the indicator is signaling that the price is trendless and that it might not be an ideal time to enter a trade.

Limitations Of ADX

Crossovers can occur frequently, sometimes too frequently, resulting in confusion and potentially lost money on trades that quickly go the other way. These are called false signals and are more common when ADX values are below 25. That said, sometimes the ADX reaches above 25, but is only there temporarily and then reverses along with the price.

Like any indicator, the ADX should be combined with price analysis and potentially other indicators to help filter signals and control risk.


Rate Of Change (ROC)

ROC Definition

The Price Rate of Change (ROC) is a momentum-based technical indicator that measures the percentage change in price between the current price and the price a certain number of periods ago.

The ROC indicator is plotted against zero, with the indicator moving upwards into positive territory if price changes are to the upside, and moving into negative territory if price changes are to the downside.

The indicator can be used to spot divergences, overbought and oversold conditions, and centerline crossovers.

Important Points To Remember:

  • The Price Rate of Change (ROC) oscillator is an unbounded momentum indicator used in technical analysis set against a zero-level midpoint.
  • A rising ROC above zero typically confirms an uptrend while a falling ROC below zero indicates a downtrend.
  • When the price is consolidating, the ROC will hover near zero. In this case, it is important traders watch the overall price trend since the ROC will provide little insight except for confirming the consolidation.

ROC Illustration:
ROC Indicator

ROC Calculations:

/*
Closing_Price(p) = Closing price of most recent period
Closing_Price(p − n) = Closing price n periods before most recent period
*/
ROC = ([Closing_Price(p) - Closing_Price(p - n)] / [Closing_Price(p - n)]) * 100

Using ROC

The Price Rate of Change (ROC) is classed as a momentum or velocity indicator because it measures the strength of price momentum by the rate of change.

Like most momentum oscillators, the ROC appears on a chart in a separate window below the price chart. The ROC is plotted against a zero line that differentiates positive and negative values. Positive values indicate upward buying pressure or momentum, while negative values below zero indicate selling pressure or downward momentum. Increasing values in either direction, positive or negative, indicate increasing momentum, and moves back toward zero indicate waning momentum.

Zero-line crossovers can be used to signal trend changes. Depending on the n value used these signal may come early in a trend change (small n value) or very late in a trend change (larger n value). The ROC is prone to whipsaws, especially around the zero line. Therefore, this signal is generally not used for trading purposes, but rather to simply alert traders that a trend change may be underway.

Overbought and oversold levels are also used. These levels are not fixed, but will vary by the asset being traded. Traders look to see what ROC values resulted in price reversals in the past. Often traders will find both positive and negative values where the price reversed with some regularity. When the ROC reaches these extreme readings again, traders will be on high alert and watch for the price to start reversing to confirm the ROC signal. With the ROC signal in place, and the price reversing to confirm the ROC signal, a trade may be considered.

ROC is also commonly used as a divergence indicator that signals a possible upcoming trend change. Divergence occurs when the price of a stock or another asset moves in one direction while its ROC moves in the opposite direction.

For example, if a stock’s price is rising over a period of time while the ROC is progressively moving lower, then the ROC is indicating bearish divergence from price, which signals a possible trend change to the downside. The same concept applies if the price is moving down and ROC is moving higher. This could signal a price move to the upside. Divergence is a notoriously poor timing signal since a divergence can last a long time and won’t always result in a price reversal.

Limitation Of ROC

One potential problem with using the ROC indicator is that its calculation gives equal weight to the most recent price and the price from n periods ago, despite the fact that some technical analysts consider more recent price action to be of more importance in determining likely future price movement.

The indicator is also prone to whipsaws, especially around the zero line. This is because when the price consolidates the price changes shrink, moving the indicator toward zero. Such times can result in multiple false signals for trend trades, but does help confirm the price consolidation.

While the indicator can be used for divergence signals, the signals often occur far too early. When the ROC starts to diverge, the price can still run in the trending direction for some time. Therefore, divergence should not be acted on as a trade signal, but could be used to help confirm a trade if other reversal signals are present from other indicators and analysis methods.