Momentum indicators
Momentum deals with the rate at which the prices are changing. For example, in an uptrend, prices are rising and the trend line slopes upward. Momentum measures how quickly the prices are rising or how steeply the trend line is sloping. Momentum is similar to acceleration and deceleration. Speed is equivalent to the slope of the price trend – the number of points gained per day, for instance. Momentum is the car’s acceleration and deceleration and is the measure of the price trend’s changing slope. The trend can be thought of as direction and momentum can be thought of as the rate of speed of the price change.
Technical analysts have developed many indicators to measure momentum, and these measures have become leading signal generators or confirmation gauges, telling us whether the trend slope is changing. When momentum is confirming the price trend, a convergence or confirmation occurs; when momentum is falling to confirm the trend slope by giving a warning signal, a divergence occurs. As a sign of price trend change then, the technical analyst often looks for a divergence. Confirmation is also used to identify overbought and oversold conditions.
In the next paragraphs, we will describe the most common price momentum oscillators. There are many ways of calculating momentum, but because all of them arrive at essentially the same result, we describe only the most common and most popular.
1. Moving Average Convergence-Divergence (MACD)
Gerald Appel, the publisher of Systems and Forecasts, developed the MACD oscillator. A variation of the moving average crossover, the MACD is calculated using the difference between two exponential moving averages. Traditionally, a 26-period EMA is subtracted from a 12-period EMA, but these times are adjustable for shorter and longer period analysis. This calculation results in a value that oscillates above and below zero. A positive MACD indicates that the average price during the past 12 periods exceeds the average price over the past 26 periods.
The MACD line is plotted at the bottom of a price chart along with another line - the signal line. The signal line is an exponential MA of the MACD; a 9 period EMA is the most common. A histogram of the difference between the MACD and the signal live often appears at the bottom of the chart.
The MACD is useful in a trending market because it is unbounded. When the MACD is above zero, suggesting an upward trend, buy signals occur when the MACD crosses from below to above the signal line. The downward crossing is not reliable while the trend is upward.
2. Relative Strength Index (RSI)
In 1978, J. Welles Wilder introduced the relative strength index (RSI) in an article in Commodities magazine. The RSI measures the strength of an issue against its history of price change by comparing “up” days to “down” days. Wilder based his index on the assumption that overbought levels generally occur after the market has advanced for a disproportionate number of days, and that oversold levels generally follow a significant number of declining days. RSI measures a security’s strength relative to its own price history, not that of the market in general. To construct the RSI, you must make the following calculations:
RS= UPS/DOWNS
RSI = 100 – |100/1(1+RS)|
The RSI can range from a low of 0 to a high of 100. In his original calculations, Wilder used 14 days as a relevant period. Overbought and oversold warnings are the same as with many other indicators. Wilder considered above 70 to indicate an overbought situation and an RSI below 30 to indicate oversold condition. Similar to other oscillators, RSI divergences with price often give a warning of a trend reversal.
3. Stochastic Oscillator
According to Gibbons Burke, Tim Slater, founder and president of CompuTrac, Inc., included this indicator in the company’s software analysis program in 1978. He needed a name to attach to the indicator other than the %K and %D we will see in the indicator calculation. Slater saw a notation of “stochastic process” handwritten on the original Investment Educators literature he was using and the name stuck.
The “fast” stochastic, as seen in software, refers to the raw stochastic number (%K) compared with a three-period simple moving average of that number (fast %D). This number is extremely sensitive to price changes. To combat this problem, analysts have created the “slow” stochastic. The slow stochastic is designed to smooth the original %D again with a three-period simple MA. In other words, the slow stochastic is a doubly smoothed moving average, or a moving average of the moving average of %K.
As in most oscillators, the stochastic works better in a trading range market, but can still give valuable information in a trending market.
4. Commodity Channel Index (CCI)
The Commodity Channel Index (CCI) is also similar to the stochastic. Donald Lambert developed this indicator, describing it in the October 1980 issue of Commodities magazine. The CCI measures the deviation of a security’s price from a moving average. This gives a slightly different picture than the stochastic, and in some cases, the signals are more reliable. However, the difference between the CCI and the stochastic is so minuscule that using both would be a duplication of effort and liable to create false confidence.
Trade with care.
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Technical analysts have developed many indicators to measure momentum, and these measures have become leading signal generators or confirmation gauges, telling us whether the trend slope is changing. When momentum is confirming the price trend, a convergence or confirmation occurs; when momentum is falling to confirm the trend slope by giving a warning signal, a divergence occurs. As a sign of price trend change then, the technical analyst often looks for a divergence. Confirmation is also used to identify overbought and oversold conditions.
In the next paragraphs, we will describe the most common price momentum oscillators. There are many ways of calculating momentum, but because all of them arrive at essentially the same result, we describe only the most common and most popular.
1. Moving Average Convergence-Divergence (MACD)
Gerald Appel, the publisher of Systems and Forecasts, developed the MACD oscillator. A variation of the moving average crossover, the MACD is calculated using the difference between two exponential moving averages. Traditionally, a 26-period EMA is subtracted from a 12-period EMA, but these times are adjustable for shorter and longer period analysis. This calculation results in a value that oscillates above and below zero. A positive MACD indicates that the average price during the past 12 periods exceeds the average price over the past 26 periods.
The MACD line is plotted at the bottom of a price chart along with another line - the signal line. The signal line is an exponential MA of the MACD; a 9 period EMA is the most common. A histogram of the difference between the MACD and the signal live often appears at the bottom of the chart.
The MACD is useful in a trending market because it is unbounded. When the MACD is above zero, suggesting an upward trend, buy signals occur when the MACD crosses from below to above the signal line. The downward crossing is not reliable while the trend is upward.
2. Relative Strength Index (RSI)
In 1978, J. Welles Wilder introduced the relative strength index (RSI) in an article in Commodities magazine. The RSI measures the strength of an issue against its history of price change by comparing “up” days to “down” days. Wilder based his index on the assumption that overbought levels generally occur after the market has advanced for a disproportionate number of days, and that oversold levels generally follow a significant number of declining days. RSI measures a security’s strength relative to its own price history, not that of the market in general. To construct the RSI, you must make the following calculations:
RS= UPS/DOWNS
RSI = 100 – |100/1(1+RS)|
The RSI can range from a low of 0 to a high of 100. In his original calculations, Wilder used 14 days as a relevant period. Overbought and oversold warnings are the same as with many other indicators. Wilder considered above 70 to indicate an overbought situation and an RSI below 30 to indicate oversold condition. Similar to other oscillators, RSI divergences with price often give a warning of a trend reversal.
3. Stochastic Oscillator
According to Gibbons Burke, Tim Slater, founder and president of CompuTrac, Inc., included this indicator in the company’s software analysis program in 1978. He needed a name to attach to the indicator other than the %K and %D we will see in the indicator calculation. Slater saw a notation of “stochastic process” handwritten on the original Investment Educators literature he was using and the name stuck.
The “fast” stochastic, as seen in software, refers to the raw stochastic number (%K) compared with a three-period simple moving average of that number (fast %D). This number is extremely sensitive to price changes. To combat this problem, analysts have created the “slow” stochastic. The slow stochastic is designed to smooth the original %D again with a three-period simple MA. In other words, the slow stochastic is a doubly smoothed moving average, or a moving average of the moving average of %K.
As in most oscillators, the stochastic works better in a trading range market, but can still give valuable information in a trending market.
4. Commodity Channel Index (CCI)
The Commodity Channel Index (CCI) is also similar to the stochastic. Donald Lambert developed this indicator, describing it in the October 1980 issue of Commodities magazine. The CCI measures the deviation of a security’s price from a moving average. This gives a slightly different picture than the stochastic, and in some cases, the signals are more reliable. However, the difference between the CCI and the stochastic is so minuscule that using both would be a duplication of effort and liable to create false confidence.
Trade with care.
If you like our content, please feel free to support our page with a like, comment & subscribe for future educational ideas and trading setups.
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