Trading

How to Trade the Momentum Indicator

October 3, 2019

The momentum indicator is one of the most popular technical indicators used in crypto trading. It belongs to the family of oscillators, which consists of a group of technical indicators that range between two extreme values (overbought and oversold). Oscillators generate trading signals when the reading approaches the upper or lower extreme levels. 

Some of the most common oscillators are the stochastic oscillator, Relative Strength Index (RSI), Rate of Change (ROC), Money Flow Index (MFI), etc. Oscillators are mainly used to gauge the current market conditions. In today’s blog post, we will be looking more closely at the Momentum Indicator.


Structure


The Momentum indicator calculates the rate of acceleration of an asset’s price. Practically, it measures the speed at which the price is changing. John J. Murphy, the US-based financial markets analyst, explained Momentum indicator in his book "Technical Analysis of the Financial Markets".

"Market Momentum is measured by continually taking price differences for a fixed time interval. To construct a 10-day Momentum line, simply subtract the closing price 10 days ago from the last closing price. This positive or negative value is then plotted around a zero line.” 


The formula for calculating Momentum is:

M=V−Vx

Where:

V=The latest price

Vx=The closing price x number of days ago


Most charting tools, including the one used by Sparkdex, allow you to set the value to which the Momentum will compare the current closing price. Usually, values 10 and 14 are used for this purpose. 


Trading Momentum

Traders use Momentum indicators in different ways. In general, there are three major schools of thought on how to use Momentum. The first group believes that Momentum is best used in the “ride the trend” conditions, contrary to the second group that believes that Momentum should be used to identify potential trend reversals. Finally, many traders and analysts use Momentum to generate “divergence” trading signals. 


  1. Ride the trend

Arguably the simplest way of using this indicator is to simply follow the trajectory of the Momentum. The price chart below shows Bitcoin, with Momentum indicator (value 10) applied.


BTC/USD momentum indicator - Ride the Trend
BTC/USD momentum indicator - Ride the Trend


The price action creates a short-term bottom as the Momentum indicator hits the lowest levels. As the Bitcoin price starts to stage a bounce, the Momentum recovers along the way. 

In this particular case, the Momentum indicator is used as a confirmation that the market conditions are changing from bearish to bullish, and we may initiate a long trade to capitalise on this change in market conditions. This is considered to be a good strategy for short-term traders.


  1. Trade extremes


Completely contrary to the first strategy, many traders use Momentum to “buy low and sell high”. This strategy is very similar to using the RSI to trade oversold and overbought market conditions. 





BTC/USD momentum indicator - Trade extremes
BTC/USD momentum indicator - Trade extremes


The Momentum indicator is set up in such a manner that it highlights extreme readings on both sides. In this particular case, we draw two lines to mark the “normal” market conditions, when the Momentum readings move between +400 and -400. Any move above +400 or below -400 issue a signal that the current market is trading in extreme conditions, hence the reversal may begin soon. 

The price chart above shows two different occasions in which Bitcoin entered the “extreme” market conditions. The apparent limitation of this strategy is that markets that are overbought can tomorrow be even more overbought. As the old saying goes: “the market can stay irrational longer than you can stay solvent”. 

Momentum signals should be used only in combination with other technical indicators and elements of the trading process.


  1. Divergence

Divergence can occur in almost all oscillator indicators, due to their design. As far as Momentum is concerned, bullish divergence occurs when the price actions creates lower lows, but the Momentum indicator does the opposite - makes higher lows. 

On the other hand, a bearish divergence occurs when prices are making a higher high, but the Momentum indicator creates lower lows. 

As seen in the Bitcoin price chart below, Bitcoin had been creating higher lows for some time. 



BTC/USD momentum indicator - Divergence
BTC/USD momentum indicator - Divergence


However, the Momentum indicator creates a new low, which diverges from the trajectory of the price action. Bearish divergence, as the name itself says, issues a sell signal in this case. Divergence is a strong signal generator, however, try to avoid it in very strong markets when the price trends strongly in one or the other way. 

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