How to Trade with the Momentum Indicator

What the momentum indicator is and how to use it.

Momentum Indicator on Intraday Chart
Momentum Indicator with "n" set to 10. FreeStockCharts.com

The Momentum indicator is a speed of movement indicator designed to identify the speed (or strength) of price movement. The momentum indicator compares the most recent closing price to a previous closing price (can be the closing price of any time frame). The momentum indicator is displayed as a single line, on its own chart, separate from the price bars, and is the bottom section in the example chart.

For charting basics, see Learn to Read and Use Candlestick Charts.

Calculation of the Momentum Indicator

  • Description: There are several variations of the momentum indicator, but whichever version is used, the momentum (M) is a comparison between the current closing price (CP) a closing price "n" periods ago (CPn). The "n" is determined by you. In the attached chart, Momentum is set to "10," so the indicator is comparing the current price to the price 10 minutes ago (because it is a 1-minute chart).

  • Calculation:
        M = CP - CPn
    Or
        M = (CP / CPn) * 100

The first calculation just takes the difference between the two closing prices and plots it. The second version of the indicator shows the price difference between the current price and the price n periods ago as a percentage.

Momentum Indicator Trading Use

The momentum indicator identifies when the price is moving upwards or downwards, and by how much.

When the momentum indicator is above 100, the price is above the price "n" periods ago, and when the momentum indicator is below 100 the price is below the price "n" periods ago.

How the far the indicator is above or below 100 indicates shows how fast the price moving. A reading of 101 shows the price is moving quicker to the upside than a reading of 100.5.

A reading of 98 shows the price is moving with more force to the downside than a reading of 99.

The momentum indicator can be used to provide trade signals, as follows, but it typically is better used to help confirm trades based on price action (breakouts or pullbacks with in a trend, as examples).

  • 100 Line Cross - When the price crosses above or below the 100 line (or zero line if the indicator is based on the first calculation) it can represent a buy or sell signal respectively. If the price crosses above the 100 line it indicates the price is starting to move higher since the price has moved above the price "n" periods ago. A drop below the 100 line shows the price is dropping since it has moved below the price "n" periods ago. 
  • Crossover - Buying and selling when the price crosses the 100 line (or zero line) often provides poor timing signals. Much of a price move will have already happened, or if using the 100 line as an exit signal, too much profit will be given up. One possible solution is to add a moving average to the indicator. Buy when the Momentum indicator crosses above the moving average from below, and sell when the Momentum indicator crosses below the moving average from above. This too has its problems; mainly, many signals will occur but not all be good trading opportunities. 
  • Divergence - If the price is moving lower, but the lows on the momentum indicator are moving higher, this is a "bullish divergence." It shows that while the price is dropping, the momentum behind the selling is slowing. If you get a buy signal, this bullish divergence can help confirm it. If the price is moving higher, but the highs on the momentum indicator are moving lower, this is a "bearish divergence." It shows that while price is rising, the momentum behind the buying is slowing. If you get a sell signal, this bearish divergence can help confirm it (see Don't Trade MACD Divergence Until You Read This for more on divergence).

Final Word on Momentum Indicator

The momentum indicator isn't going to give a trader much information over and above what can be seen just by looking at the price chart itself.

If the price is moving aggressively higher, this will be visible on the price chart and on the momentum indicator. The momentum indicator can be useful for spotting subtle shifts in the force of buying or selling though, mainly through the use of divergence. The momentum indicator is best used in conjunction with a price action trading strategy, providing confirmation as opposed to using the indicator to generate trade signals on its own.