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For the DIY trader, employing technical analysis indicators not only provides clues as to price movement but additionally helps discourage decision-making based on emotions. Momentum indicators, sometimes referred to as rate-of-change oscillators, are a popular technical analysis tool in modern trading known for broadening a trader's perspective - but what are they are and how do you apply them to your charts?

There are many different types of momentum indicators, with slightly varying formulas, but overall they are useful to traders who want to:

  1. highlight short-term overbought or oversold levels, and
  2. reveal when price movement and momentum are in disagreement e.g. if price keeps rising but has slowed significantly, the indication here is waning enthusiasm.

This brings us to oscillators, a popular branch of momentum indicators. Oscillation literally means movement back and forth, like a swing. So an oscillator in the technical analysis world measures the swings up and down in price over a specific time-frame. When applied to charts, we see the oscillators as fluctuating line(s) on the plot, and this help to give an indication of price direction and momentum. There are two types of momentum oscillators:

Tip 1

Centred Oscillators fluctuate above and below a central point (line),
    ⚬ better suited for finding direction and strength of price momentum.

Banded Oscillators fluctuate above and below two bands that signify extreme price levels (overbought/oversold).
    ⚬ better suited for identifying overbought and oversold levels.

Centred Oscillators
Examples of Centred Oscillators are the Examples of Centred Oscillators are the Moving Average Convergence/Divergence (MACD) & Rate of Change (ROC).

ROC is simply the percentage change in price from one period to the next i.e.
Momentum = close (today) - close (x number of periods ago).

The plot forms an oscillator that moves over and under the centred line. It is a straightforward and useful tool for gauging momentum but is sometimes undeservedly overlooked due to its simplicity.

The MACD differs in that it finds the difference between a shorter- and a longer-term moving average and plots this as a single line. The default settings in most charting packages (including EzyChart) is a 12-day Exponential Moving Average (EMA) and a 26-day EMA. The further one EMA moves away from the other, the higher the oscillator reading.

Tip 2

Banded Oscillators
Examples of Banded Oscillators are the Relative Strength Index (RSI) & Stochastic.

The RSI oscillates between three zones - above 70 (overbought); between 70 and 30 (neutral) and below 30 (oversold). Most Banded Oscillators work on the basis that the indicator wants to trend towards 50, so there is a higher probability that the stock will trend upwards when the indicator is below 30.

Tip 3

The stochastic oscillator compares a stock's closing price to the range of its prices over a certain period of time. The theory behind this indicator is that prices on the uptrend close nearer their high whilst downward trending prices close nearer their low. In other words, momentum changes before price does. Signals or triggers occur when the %K (Oscillator) crosses the %D (Signal) line. It's a bullish signal when the Oscillator line rises above the Signal line and a bearish signal when it falls below the Signal line.

Final Thoughts
If you consider adopting momentum indicators into your trading strategy, we recommend spending time experimenting with them first i.e. trying differing timeframe lengths and practicing with historical charts. If you'd like to see how to apply momentum oscillators to your charts, we've created this video that applies two well-known momentum indicators - the MACD and the RSI.

Before you go, it is important to reiterate that momentum indicators do not necessarily foretell the direction of price movement. When reading your charts, if you notice price momentum is starting to change, it is safer to wait until the actual price direction confirms this momentum signal.

First Published: 31 July 2018 - Copyright © Electronic Information Solutions Pty Ltd 1990 - . All Rights Reserved.

Electronic Information Solutions Pty Ltd (ACN 011 060 012) T/A JustData is not a licensed investment advisor. This publication, which is generally available to the public, falls under the ASIC Media Advice provisions. The information provided is for educational purposes only and does not constitute financial product advice. These analysis notes are based on our experience of applying technical analysis to the market and are designed to be used as a tutorial showing how technical analysis can be applied to a chart example based on recent trading data. This article is a tool to assist you in your personal judgment. It is not designed to replace your Licensed Financial Consultant or your Stockbroker. It has been prepared without regard to any particular person's investment objectives, financial situation and particular needs because readers come from diverse backgrounds, with diverse objectives and financial situations. This information is of a general nature only so you should seek independent advice from your broker or other investment advisors as appropriate before taking any action. The decision to trade and the method of trading is for the reader alone to decide. The author and publisher expressly disclaim all and any liability to any person, whether the purchase of this publication or not, in respect of anything and of the consequences of any thing done or omitted to be done by any such person in reliance, whether whole or partial, upon the whole or any part of the contents of this publication. Neither Electronic Information Solutions Pty Limited nor its officers, employees and agents, will be liable for any loss or damage incurred by any person directly or indirectly as a result of reliance on the information contained in this publication.