How To Use Momentum Indicators In Real Life Trading?

Let us first understand what is momentum in the stock market.

Prices of shares go through various phases of ups and downs all the time. During such movement, they manifest a type of inertia whereby a stock whose price sees an initial increase attracts more buyers which increases the buying pressure and consequently the price and trading volumes even further, thus creating a trend or a momentum. Such momentums are often reversed too when a stock becomes overpriced due to the uptrend momentum and then suddenly drops in price as a part of market correction in the form of a downtrend momentum. 

Momentum indicators are specific data points that allow us to understand the overall trend that is being created by a volatile stock price – they cut out the unnecessary noise from all the data and help us identify or predict a momentum early on.

What are the major momentum indicators?

The major momentum or trend indicators are Simple Moving Average, Exponential Moving Average, Weighted Moving Average, Bollinger Bands, Moving Average Convergence Divergence (MACD), Relative Strength Index, Intraday Momentum Index, Supertrend Indicator among others.

For example, a simple moving average crunches past data into a single number to hide short-term volatility and give us an idea of the emerging trend. It gives equal weight to all the units in a particular range of time. In contrast, the exponential moving average or EMA gives higher weightage to more recent price changes. If the stock price moves past the 200-day EMA it indicates that a reversal has occurred.

How to use momentum indicators?

The momentum indicators may be used to identify support and resistance levels, predict breakouts in prices and arrange investments accordingly. There are a few trading strategies that momentum indicators can help execute:

1. Momentum trading –

   Suppose you see a momentum getting built up in the market e.g. Apollo Tyres witnessing a 2-3% increase in price per day. You can confirm the existence of such a momentum by checking if the 26 day EMA has consistently been breaking out of the 200 day EMA and if the trading volume has been increasing due to increased buying pressure – perhaps due to a sustained increase in stock prices in the automobile sector. Therefore if you buy the Apollo Tyres stock, hold it until the 26 day EMA once again comes down to the 200 day EMA and then sell it, you are said to have undertaken a momentum trading strategy.

2. Flat top breakout –

   A flat top occurs when the price faces sustained resistance against a bullish trend – the price rises only to end up plateauing at a certain level. As a result, over time, the moving averages of various time periods converge. However, such patterns usually end up in a bullish breakout. In such cases, the trader can buy the stock and place a good till trigger order that will initiate sell orders once a particularly high price is reached.

3. False breakout –

   It is the case where a price appeared to briefly break out of stagnation, only to reverse its momentum – thereby eliminating the strategies that were based solely on momentum and not on fundamentals. To avoid losing money on false breakouts, it would be a good idea to consider long term EMAs of 200 days or more – thereby expect overpricing if the 12 day EMA has crossed the 50 day or 200 day EMA without any significant event whatsoever (such as announcement of earnings, launch of new products etc.).

4. Flag pattern –

   In this case, the price sees a sharp increase or decrease disrupted by a period of fluctuation in a rectangle pattern. A flag pattern breakout can be identified by a golden cross i.e. when the short term moving average rises above the long-term one – indicating an uptrend breakout. 

Things to keep in mind

1. Have a pre-planned entry and exit strategy –

   Decide beforehand when you are going to buy a stock (preferably when it is underpriced and about to have a bullish breakout) and sell it (when you are certain that there will no longer be any further riskless price rise). 

2. Know the risks of momentum indicators –

   Many of the momentum indicators such as moving average are lag indicators i.e. they are based on data of past prices and cannot predict with certainty what the price will be in the future.

3. Bid-Ask Spreads –

   A high spread means the momentum will have to be greater for you to earn a profit.

Conclusion

Now that you know about how to use price action to identify momentums in stock market prices, try opening a demat account and start trading on your own.

FAQs

Q1. What are the top 5 momentum indicators?

Ans. The top 5 momentum indicators include: 1. Moving Average 2. Relative Strength Index 3. MACD 4. Intraday Momentum Index 5. Supertrend Indicator

Q2. How to understand the meaning of momentum indicators?

Ans. Momentum indicators largely provide us with understanding of whether the stock price is witnessing a relative increase or decrease. Check out the definition of each indicator and check the market trends in order to understand the degree of impact of any change in momentum indicators. 

Q3.Do I have to calculate the momentum indicators myself?

Ans. Indicators such as moving averages are usually given by brokerage platforms and other websites, so you don’t have to calculate them.

Q4. Which is the best trend indicator for momentum trading?

Ans. As such no single indicator can be the basis for an entire strategy. However, since momentum trading is used largely by intraday traders, the RSI and MACD are some of the most favoured indicators.

Q5. What is momentum trading?

Ans. Momentum stock trading involves devising trading strategies based largely on the momentums in the prices in the stock market due to buying or selling pressures. It involves more technical analysis of prices rather than fundamental analysis of companies.

Q6. What is Relative Strength Index (RSI)?

Ans. It observes the average profits and losses over a few specific periods, typically 14 periods, determining whether the assets are overbought (if indicator is above 70/100) or oversold (indicator is below 30/100) in the market, causing a trend to form. 

Q7. What is Intraday Momentum Index?

Ans.  It checks the proportion of gains compared to overall volatility in the stock price. The stock is considered overbought if the IMI is above 70 and underbought if below 30.

Q8. What is Supertrend Indicator?

Ans. It is a trend indicator plotted upon prices and it gives signals on buying (when price is below the supertrend) and selling (when price is above the supertrend).

Q9. What is Moving Average Convergence Divergence (MACD)?

Ans. The Moving Average Convergence Divergence (MACD) indicator is the difference between the 12-day EMA and 26-day EMA. It helps traders find the average price of a security over a specific timeframe. 

Q10. What are Bollinger Bands?

Ans. They are made of three bands closely following the assets’ price. The middle band serves as a moving average e.g. Exponential Moving Average. The edges of the indicator follow the asset’s price volatility. The volatility decreases as the bands move closer, making a breakout expected.