What Are Momentum Indicators?

Momentum indicators are technical analysis tools used to determine the strength or weakness of a stock's price trend. Momentum is the rate at which a stock's price changes.

Common momentum indicators include the relative strength index (RSI), the moving average convergence divergence (MACD), and Bollinger Bands. This article looks at the RSI in particular.

Key Takeaways

• A momentum indicator can point to the strength or weakness of a price trend.
• Common momentum indicators are the RSI, the MACD, and Bollinger Bands.
• Standard overbought and oversold levels on RSI charts are 70 and 30.
• Changing the standard levels to 80 and 20 can help traders avoid false buy and sell signals.
• A momentum indicator is best used in conjunction with others that can confirm its alert.

Understanding Momentum Indicators

Momentum is the rate at which a stock's price rises or falls. Thus, momentum indicators can give traders and investors an idea of how strong a stock's price trend may be. In turn, that can help them decide when to enter or exit a trade.

Studying the prices that assets reach clearly is useful for those who take positions in the market. But momentum indicators can provide additional useful insight related to the trends of prices.

Getting in on trends, whether prices are going up or down, is a time-tested way of securing profits. Getting out of trends around the times that they reverse is a way to protect profits.

History has shown that information about momentum is far more useful during rising markets than falling markets.

That's because markets rise for longer periods of time than they fall. In other words, bull markets tend to last longer than bear markets.

RSI

The RSI was created by J. Welles Wilder Jr. in the late 1970s. His book “New Concepts in Trading Systems” (1978) is now an investment classic.

The RSI measures the speed at which prices change and the magnitude of those changes. On a chart, RSI assigns stocks a momentum value between 0 and 100. Once these numbers are charted, they can be compared to standard thresholds.

Usually these standard thresholds are the level settings of 70 and 30. They are intended to serve as clear warnings of, respectively, overbought and oversold assets.

A trader may choose to reset the RSI parameters to 80 and 20, or even 90 and 10. Doing so gives more room to overbought and oversold territory. That may help traders avoid false trade signals and pulling the trigger on a trade too early.

Experts generally chart the RSI on a daily time frame rather than hourly. However, sometimes shorter hourly periods are charted to gain insight into whether it's a good idea to make a short-term asset purchase. 

Difference Between RSI and Relative Strength

There has always been some confusion about the difference between RSI and relative strength (RS). Relative strength compares the price of a stock to a different stock or the market as a whole.

Traders use RS to pinpoint investments to trade based on their outperforming the comparison benchmark (stock or index).

On the other hand, and as mentioned, RSI measures the velocity of the changing price of a stock. It can indicate whether or not an asset's price action reflects overbuying or overselling.

The formula for the relative strength index is:

RSI = 100 − ( 100 1 + R S ) RS = Average of x days’ up closes Average of x days’ down closes where: R S I = relative strength index begin{aligned} &textbf{RSI} = 100 – left(frac{100}{1 + RS}right)\ &textbf{RS} = frac{text{Average of x days' up closes}}{text{Average of x days' down closes}}\ &textbf{where:}\ &RSI= text{relative strength index} end{aligned} ​RSI=100−(1+RS100​)RS=Average of x days’ down closesAverage of x days’ up closes​where:RSI=relative strength index​

Use RSI With Other Indicators

Ultimately, RSI can help to determine low-probability and high-reward setups. It works best when used with other momentum indicators, such as short-term moving-average crossovers.

For example, the lines of a 10-day moving average and a 25-day moving average may cross over each other and indicate a shift in a trend's direction.

These may occur very close to the times when the RSI is either in the 20/30 or 70/80 range. Together, they provide distinct overbought or oversold readings.

The RSI can alert traders to an upcoming trend reversal, either up or down, sooner than other indicators. However, keep in mind that trending prices can keep moving in the trend direction after RSI indicates an overbought (or oversold) situation.

RSI + MACD

Other indicators, such as the MACD, can be used along with the RSI to confirm trend reversals. While RSI alerts traders to possible overbought or oversold price levels, MACD can signal a divergence from the trend. Traders may feel more confident taking or exiting positions when a second indicator confirms the alert provided by RSI.

Example

Many traders view the RSI value of 50 to be both a support and resistance benchmark level.

If a stock price that's rising has a difficult time breaking through 50 on the upside, resistance may be too strong at that particular time. Price action may fall off until there is enough volume to break through and continue on to new and higher levels.

A stock that's falling in price may find support at the 50-value level and bounce off it again before moving upward in price.

Why Are Momentum Indicators Useful?

They're useful because they provide traders with insight into the strength of trending prices, and whether they are weakening and may reverse. That can help investors, and in particular active traders, understand whether they should get in, stay in, or get out of the market.

Do Momentum Indicators Have Disadvantages?

Yes, they do. They lag behind actual price movements so the information they provide isn't always reliable. This is especially the case when markets are volatile and prices move up and down sharply.

Is RSI a Trend or Momentum Indicator?

It's a momentum indicator that measures the velocity at which asset prices change. Its data relates to price trends because it can indicate an overbought or oversold asset and therefore a price trend that may weaken and reverse.

The Bottom Line

Momentum indicators shed light on the strength or weakness of a price trend because of their focus on the rate at which prices change.

The relative strength index, or RSI, is one such indicator. Based on standard levels of 70 (overbought) and 30 (oversold), or more extreme levels if preferred, traders can determine possible entry and exit points for their trades.

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