Key Momentum Indicators for Retail Investors

Momentum trading is a classic strategy, with studies reporting its success as far back as the early 19th century. Over the last 10 years, MSCI’s momentum index has outperformed its comparable market-cap weighted index by 1.4% per year (Data as of August 31st, 2022). Using past price movements and technical indicators, momentum trading can be used to capitalize on assets already on the move. If done right, momentum trading can identify trends and divergences, often delivering returns over the broad market.

But how do we decide which assets are on an uptrend and which are on a downtrend? We do this with a variety of momentum indicators.

Related: What is Momentum Trading? Everything you Need to Know >

What are Momentum Indicators?

Momentum indicators are tools for the technical analysis of stocks and assets. While past performance does not guarantee future results when applied correctly, they can use the past performance of assets to help investors visualize future potential price moves. Using these different momentum strategies is relatively easy if you have a basic knowledge of algebra and formulaic math. While the most cutting-edge financial theory is constantly changing, there are a few popular momentum indicators that have stuck around for years or even decades.

Moving Average Convergence Divergence (MACD)

MACD, or Moving Average Convergence Divergence, is considered by many experts to be one of the best momentum indicators. MACD is best described as a trend-following momentum indicator that uses the divergence between two moving averages of a security’s price to deliver trading signals. MACD is determined by subtracting the 26-day exponential moving average (EMA) from the 12-day EMA, as shown below:

MACD = 12-day EMA − 26-day EMA

The resulting MACD line is often plotted on a chart and compared to a standard nine-day EMA known as the signal line. The relationship between the signal line and the plotted MACD line can give investors a perspective on where prices may move in the future. Divergences and crossovers of the two lines can show breakout performance or falling interest in a security, often indicating buy signals and sell signals.

Relative Strength Index (RSI)

RSI, or Relative Strength Index, is another technical indicator. A properly calculated RSI considers the speed and magnitude of an asset’s price changes to determine if the stock is overbought or oversold. Similar to the MACD, RSI is plotted on a graph, showing how a security scores in a given time frame. RSI is also beneficial because it can indicate possible corrective pullbacks in price.

Developed by Welles Wilder in 1978, the formula for RSI is:

RSI = 100 − [100 / (1 + (average gain / average loss))]

While traders develop their own perspective on breakpoints for individual assets, an RSI of 30 or below is often considered oversold, while an RSI of 70 or higher is considered overbought.

Price Change

Another classic momentum indicator is simply the price change of a given stock over a pre-determined period of time. There is debate among traders about the ideal length of time to evaluate trends. Measurements over longer time periods (e.g., 12 months, 200-day moving average) capture longer-term trends and are less likely to show false signals. Measurements over shorter periods are more responsive to changes in market conditions but may flip quickly between buy and sell signals, creating uncertainty for momentum traders. Check out our Step-By-Step Guide to Building Momentum Trading Strategies blog for a discussion of different look-back periods.

The price change is an essential metric for determining bullish divergence and bearish divergence. While the current price of a stock is the most simple momentum indicator out there, it’s important to remember its value. An equity’s price change and price action reflect all the information available and are visible to every type of investor, even beginners.

Stochastic Oscillator

A stochastic oscillator is a momentum indicator that primarily uses closing prices over specific periods to calculate divergence. Stochastic oscillators are good at finding undersold and oversold conditions in the stock market.

The formula for stochastic oscillator is:

%K = (C − L14 / H14 − L14) × 100

The variables are defined as:

C = The most recent closing price

L14 = The lowest price traded of the 14 most recent trading sessions

H14 = The highest price traded during the same 14-day period

%K = The current value of the stochastic indicator, range-bound by 100

Rate of Change (ROC)

ROC, or Rate of Change, is another relatively straightforward momentum indicator that can help to determine a stock’s momentum. Simply put, ROC measures how quickly something changes over time. Instead of measuring the magnitude of changes, ROC measures acceleration and deacceleration of trends. The formula for ROC is:

R = (P2 - P1) / T

The variables are defined as:

R = rate of change

P = Price (or similar variable) measured at the beginning and end of the period

T = how long it took for the change to occur

Advantages and Disadvantages of Momentum Indicators

As with any essential tools, all of these momentum indicators will only work well if used in the proper context. In other words, the market environment and consistent application of the rules matter! It is also worth noting that momentum strategies are prone to crashes during market rebounds (e.g., after the Global Financial Crisis) and therefore do well when paired with value investing strategies.

Composer can help you start momentum investing by automating trading based on price changes, RSI, moving averages, and exponential moving averages (EMA). Composer can help you keep the big picture in focus with custom-built and constantly updated charts and metric trackers. Like any investment tool or strategy, momentum trading and momentum indicators are best used in the right applications. Let Composer help you contextualize your trading strategy.

Related: Best Books on Momentum Trading >

Using Composer to Manage Momentum Indicators

As with most technical trading, investing via momentum indicators can be complex and time-consuming. Not only do you have multiple data points to watch constantly, but you also need to understand what positive signals indicate for each metric and what to do about conflicting indicators.

Composer can automate momentum investing, allowing you to trade based on stock prices, RSI, moving averages, and exponential moving averages (EMA). Creating rules and automating trading makes it easier to implement the momentum indicators that matter to you and act on them in a timely, organized fashion.