One of the key concepts in technical analysis is the idea of trend. Many strategies rely on identifying whether the market is in a trend or not — and from there, working out if a trend is beginning or coming to an end. Knowing whether a trend is starting up or just about to break down is an extremely useful piece of information to have at your disposal.
Part of knowing whether a trend will continue comes down to judging just how much gusto lies behind the move. This strength behind the trend is often referred to as momentum, and there are a number of indicators that attempt to measure it.
Some of the better-known momentum indicators are Relative Strength Index (RSI), Stochastic and Moving Average Convergence Divergence (MACD). You can read more about MACD in our list of the most important Forex indicators.
RSI and Stochastic are both oscillators, meaning their values move between a bounded range (often between 0 and 100). This article is going to discuss another momentum oscillator that some argue is just as effective as its more famous counterparts. This is the momentum indicator, which plots a curve that oscillates either side of a centreline value of 100, as we shall see.
Like RSI and Stochastic, the momentum indicator can help to identify when a market move is overbought or oversold. That is, to show whether enough momentum remains behind a trend to keep the price-move going. When a falling market is oversold, it may be about to bounce. When a rising market is overbought, it may be about to fall.
Let's look at using this indicator with MetaTrader 4.
The momentum indicator comes as one of the standard indicators that are available as part of the default version of MT4.
The calculation behind the momentum indicator is fairly straightforward. The indicator works by making a comparison between a certain price and the price a set number of periods before that. The first step is to choose a value for N, the number of periods that will be used for the comparison. The momentum MT4 default value for N is 14, but you can set it to whatever value you see fit to use.
So our two comparison prices are the closing price of the current bar and the closing price N bars ago. The formula for momentum is then as follows:
Momentum = (current close/close N periods ago) x 100
The good news is that MT4 does the calculations all for you in an instant and displays it for you in a supplementary chart below your main chart.
This is how it looks:
In the hourly GBP/USD chart above, you can see I have added the momentum indicator, which appears as a single blue line at the bottom. The peaks and troughs of this line reflect key shifts in the momentum of the Forex rate.
(Note that MT4 does not mark the centreline of 100.)
You can see that over the course of our chart, the momentum indicator varies from about 100.60 down to 99.44. The further above 100, the faster the price is moving upwards. The further below 100, the faster the price is moving down.
As we said before, the momentum indicator is one of several trend-gauging oscillators available with MT4. You also have access to RSI and Stochastic.
As a sidenote, there are other momentum indicators out there, such as the MT4 Stochastic Momentum Index (SMI), but you will have to download these as custom indicators if you are interested.
You can use the momentum indicator to provide trading signals directly, but it is more commonly used as a confirmation tool.
The simplest signal is to take any cross across the centreline as a signal, buying when the value rises from beneath 100 to above and selling when it drops below 100 from above.
This is a rudimentary approach, though, and should be considered with great caution. The timing of such signals can be tardy, meaning you miss most of the move by the time the signal arrives. The timing can, however, be improved with the use of a moving average in conjunction with the momentum indicator.
Some traders like to smooth the momentum curve using a simple moving average (SMA).
You can do this by clicking on Moving Average in the selection of Trend indicators in MT4's navigator and dragging and dropping it into your Momentum Indicator chart. This will bring up a typical dialogue box. In the Parameters section choose First Indicator's Data from the Apply to dropdown menu as shown below:
The image below shows the SMA added to the momentum indicator as a red line:
The trading strategy now becomes to buy when the momentum line crosses above the SMA and sell when it crosses below the SMA. This should improve the timing of the signal slightly, but still has the drawback of offering many false signals.
The indicator really comes into its own when used as a means of confirming signals from a separate, primary indicator. One of the best momentum indicator methods is to look for divergence between price and momentum as a way of measuring the strength behind a move.
So your buy or sell signal would come from whatever you have chosen as your primary indicator. You would then seek to confirm the signal via the momentum indicator by looking for whether price/momentum divergence is either bullish or bearish.
Bullish divergence suggests an oversold market. If the price falls to new lows but the momentum indicator fails to make new lows, this is a bullish divergence. Bearish divergence suggests an overbought market. If the price rises to new highs but momentum fails to make a new high, this is a bearish divergence.
You would only follow a buy signal from your primary indicator when confirmed by bullish divergence from your momentum indicator. Similarly, you would only follow a sell signal when confirmed by bearish divergence.
It's often useful to combine dissimilar indicators in this way, so that the differing aspects in their methods complement each other. Another example of this is combining momentum with volatility measures to form a squeeze momentum indicator.
Bollinger Bands provide a guide to volatility, widening in times of high volatility and narrowing when volatility is low. A Bollinger band squeeze is when volatility narrows to a historically low level. Such periods are likely to be followed by a significant move, or so the theory suggests.
The direction of the breakout is not indicated by the Bollinger bands indicator, though. A squeeze momentum strategy would use momentum as the means for gauging the direction.
If you're interested in expanding the number of indicators you see in MT4, you should check out MetaTrader 4 Supreme Edition. It's a free plugin for MT4, with a selection of extra tools and indicators that have been chosen and developed by our in-house experts.
As we have seen, the momentum indicator is a useful tool with a broad range of applications. The same tool can be used as a stock's momentum indicator and as a Forex momentum indicator.
The versatility of the indicator also means you can easily create momentum trading systems that work in the short-term as well as the long. As a general rule for the momentum indicator, the shorter the timeframe used, the more sensitive the performance. This comes with the catch that it is likely to generate more false signals than a longer time frame.
Its broad applicability means the momentum indicator could be the tool for you, whether you're a day trader or position player. Of course, as we discussed in the first part of the article, the momentum indicator is not the only way of measuring the strength of the trend. There are plenty of other momentum indicators out there.
So if you want to determine which is the best momentum indicator for day trading or long-term trading, what can you do? The smart way is to use our demo trading account and decide for yourself which is the best momentum indicator in MT4. Rather than taking someone else's word for it, you'll know for sure what works best for you.