The Beginner’s Guide to Technical Analysis Part 8: Momentum Indicators
If one thing is certain about Forex, it is that it trends. Not always and never forever, but market trends do definitely emerge, and do definitely continue – sometimes for months or years.
One currency will trend against another, as long as there are enough buyers (for an uptrend) or sellers (for a downtrend) to sustain the move. Trends in Forex can be strong… and they can be lucrative for the trader with the know how to capture them.
There are a number of ways we can plot, chart, poke and prod trends to see what they’re up to and where they might be headed, but one excellent way of doing this Is by using momentum indicators. Indicators that can be used for momentum Many of the previous indicators we have covered in this guide can be used to gauge momentum. These include:
- Moving average crossovers
Some indicators are specifically designed for this purpose. We will cover some of those here.
It is also worth noting that some momentum indicators can be used to tell both when the momentum is beginning and coming to an end.
The first indicator that can be used in momentum studies is the aptly named “momentum”.
The momentum indicator simply calculates the rate of change between the current price and the price of X number of periods ago.
As the momentum increases upwards, it signifies a bull trend. If it increases downwards, it is a sign of bear trend.
There are three main ways a technician uses a momentum indicator.
- Momentum is used to determine changes in a trend. To do this, you mark trend lines on the momentum indicator. A break of the trendline indicates a change in trend.
- If price and momentum are both moving in unison, it is a sign of a clear trend. You can then trade in alignment with the trend.
- Once the momentum starts to diverge from the trend in price, then this is a sign that the trend may be coming to an end. You can then take profit, or perhaps stalk a reversal.
Average Directional Movement Index (ADX)
The ADX is like a friend with a really good instinct. If the ADX starts to perk up, you can be assured something’s in the air, even if you can’t be sure exactly what.
In essence, the ADX indicates (a) whether or not there is a trend to speak of, and then (b) how strong or weak the trend is. Its job is to keep a detailed record of how things have been going, so that it becomes clear very quickly when something might be about to go down.
The ADX was developed by Welles Wilder. It compares recent highs and lows to determine the strength of the trend. Unlike the momentum indicator above, it does not measure the direction of the trend, just its velocity.
The ADX has three parts. Aside from the main component itself, the +DI and -DI can be useful for planning your entries in trending markets. The strength of the trend is measured by a scale. The higher the number, the stronger the trend.
There are two main ways traders use the indicator:
1. To make sure you are trading only trending markets, wait for the ADX to be trading above 25. Alternatively, you can work out a level that suits the markets you are trading. For example, some currency traders will take the ADX trading above 20 as a sign that a trend has emerged. This keeps you from getting caught trading choppy markets. (Note: you might want to mark your level on the indicator using a horizontal line)
2. Secondly, you can look for crossovers. If the +DI crosses above the –DI, then it can be a signal to buy, and vice versa. Note that for the signal to be valid, the ADX should be above the 25 line, or the level you have pre-determined.
Note: there are facets of the ADX indicator that give you the direction of the trend also. These are a secondary consideration because for our purposes the direction should be fairly self-evident. They are still well worth looking into if you feel like doing some self-directed study.
This is a very handy indicator to get to grips with, because it allows you to identify overbought/oversold conditions, and then look to trade momentum swings between the two levels.
So what do we mean by overbought and oversold with this indicator? You can see that the Williams %R value is charted between 0 (the top) and -100 (bottom).
If the Williams score is high (above -20), then the pair is said to be overbought. If it’s low (below -80), it’s said to be oversold. The basic theory is that a correction, even if a small one, should eventually bring the Williams score to a more equilibrial point. In other words, nothing can stay overbought or oversold forever…
So, for example, say the price is making new lows in a normal downtrend. The indicator is showing you that the pair has moved from -60 to -90 very quickly. It is now oversold. You might look to go long, as those who are short take profits, and those who are flat go long with you.
What momentum traders will look to do is trade the swings between the overbought and oversold conditions. This can be done by trading the crosses back over the -20 and -80 lines.
You will note this indicator does a slightly different job than the ADX and momentum. Its focus is more on capturing the short-term swings in momentum, while the others keep you trading with the longer-term trend. Because of this, it is perhaps better suited to trading the swings within a wider range trading market.
To make the most of this lesson, jot down some of the ideas you like the most and how you might apply them to your trades.
You might just surprise yourself with some great insights.
And remember, there are no hard and fast right answers with technical analysis. Take your time. Play with the indicators until they are doing the job you want to them to do.
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