How Can Traders Use Momentum Indicators to Read Market Trends?

In terms of understanding price action, price tells us where a market has been. Momentum on the other hand tells us how hard a market is working to get to where it is going. This is particularly important near the extremes of a trend, where it helps us understand whether an emerging trend is strengthening, or collapsing.

Momentum indicators are also derived from price (as are price indicators), so they have the same advantages and disadvantages as price indicators. They can be used to make trades but generally, are used to confirm price trends or to make entries in opposition to current trends. A very popular momentum indicator is the MACD Indicator, which is made up of a spread between two exponential moving averages and a signal line off of the spread. The MACD Indicator is very popular because it packs three different readings into one graph, direction, rate of change, and change in rate of change.

Separate the question of direction from the question of strength

There’s a huge amount of material available online on the subject of momentum analysis. Most of it fails because it tries to use a single indicator to answer two questions at once, structure (i.e. The trend), and strength (i.e. The way that trend is currently being expressed).

You first establish the direction (a structural question) on a larger time frame, and then use the indicator to help with timing entries and managing risk on the smaller time frame that you trade on. A downward moving oscillator in the middle of an established uptrend can indicate a pull back, and be totally different when the market is oscillating between two polarities. In a symmetric trading range the oscillator will fluctuate all over the place.

Match the lookback to the holding period

A fourteen period oscillator on a 5 minute chart is not to be confused with a fourteen period oscillator on a daily chart. Remember that the lookback for an oscillator should approximate the amount of time that the average trade makes it through in terms of amount of time between price swings. Thus, a 14 period average on a 5 minute chart is smoothing out twenty or so 5 minute sessions. On a daily chart it would confirm an exit to a trade that had been held for three days or so.

Moving averages, crossovers, and the quality of the cross

I personally consider moving average crossovers to be trend filters rather than trade signals. As such they have value in forcing a trader to take a binary view on the market and reduce discretionary decisions. The cost of using moving averages as trend filters is lag, and this is directly proportional to the length of the longer average.

Here are three factors to consider when grading a cross

• The angle of separation. Averages that cross while both are flat indicate a range, and the signal will likely reverse within a few bars.
• The distance traveled since the previous cross. Frequent alternation is a reliable sign the smoothing length is wrong for current volatility.
• Confirmation from the histogram or rate of change. A cross that occurs while the underlying spread is still contracting is a late signal on a move that has already matured.

Zero line behavior

For spread-based tools, the zero line of the underlying tool (e.g., a moving average spread) serves as the intersection point of the two averages. Signal line crossovers above and below zero need to be analyzed within the context of whether they occurred on the proper side of zero to start with. Showcasing the vastly different base rate of said signal line crossovers versus those that occur against the signal line’s zero point (i.e., opposite of expected) in a simple chart isolation study on the underlying tool often removes a large portion of irrelevant signals.

Divergence, read properly

The term “divergence” in trading is very misused. The layman’s understanding of it is as a reversal sign. In reality a price making a new extreme and an indicator not making a new extreme only shows that the rate of price movement is decaying. That means it can make a reversal, but it can also enter into a consolidation or even a prolonged continued move.

Don’t open a trade opposite of where price is going on the basis of a single negative divergence event. Require confirmation. That can be a failure by price to rise to a new high and break through the swing low of the last peak (i.e. Reversal) or a failure by price to fall to a new low and drop back below the swing high of the last trough (i.e. Reversal).

Choosing the right tool for the regime

Avoid stacking correlated readings

Most of the time, three different oscillators based on the same data will have similar readings. As a result, it’s easy to use several indicators. But you should pair a momentum indicator with another indicator that is based on a completely different data source, such as volatility, volume or even a market breadth indicator. If the spread based family is the one you lean on, it is worth studying how the MACD indicator is constructed before you add anything alongside it.

Turning readings into decisions

A momentum signal must map to a specific action with an invalidation point. Draw the sequence out explicitly.

1. Classify the regime on the higher timeframe as trending, ranging, or transitioning.
2. Select the momentum tool suited to that regime rather than defaulting to a preferred one.
3. Define the entry trigger, the invalidation level, and the position size before the signal fires.
4. Record the regime classification alongside the outcome so you can measure which conditions your reads actually work in.

In the end, that is where most of the improvement comes from. The hit rate for a momentum indicator is conditional on the state of the market when it was applied. The only way you will know what that hit rate is, is by keeping records of your own trading results.