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You’re standing on the shore of a beach on a hot sunny day. As you’re building your sand castle a big wave rushes in and destroys the whole thing!

The momentum in the waves can increase with several surrounding factors like wind, temperature etc. Market momentum is similar as the wave of these prices comes in all different strengths, directions and movements. These movements are used to analyze markets and understand trends. The currents in the ocean are much stronger in the night, like certain market conditions cause big movements of prices and form trending areas.

Mastering market momentum allows traders to enable capitalizing on trends, predict reversals and manage risk effectively. It can also help traders mark support and resistance areas, similar to how far a wave would reach into the shore.

If you were to tally how far a wave reached each time you would sure be able to come up with an average, expecting where it might go. This would save you from wrecking your magnificent build just like it would save traders from hitting their Stop-Loss. Momentum indicators work the same by measuring the rate of price change in a stock over a set period.

Identifying the momentum of different markets can be done by countless indicators. This article will take a deep dive into Moving Averages, MACD (Moving Average Convergence Divergence) and RSI (Relative Strength Index).

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Moving Averages:

The Basics

A moving average is a simple line that calculates the closing average from a set amount of pervious candles. Each candle the MA passes shows the average of the candles previous to it. A closing price higher than the given moving averages, means the stock is currently pricier than its previous time-frames/candles.

There is two types of moving averages which are the SMA and EMA. The SMA (simple moving average) cancels out unnecessary noise, whereas the EMA (exponential moving average) is more responsive to small fluctuations in price

Recognizing Trends

The most popular Moving Averages are the 20/50/100/200 MA. Each average is used to determine the direction and trend of a market.

Larger moving averages represent long-term trends as they account for more previous data. Smaller moving averages are used to identify short-term trends, beneficial for day/swing trading. Techniques to recognize the different trends are listed below:

1. Bullish/Bearish: If the MA is below the current candles it indicates the price is headed to the incline as buyers have recently been putting more buying pressure than before (look for buying opportunities). If the MA is over the current candles it indicates the price is headed to the decline as seller have recently been putting more selling pressure than before (look for selling opportunities). The steepness of the line aligns with the strength of the trend.

2. Consolidation: If the price is frequently crossing below and over the MA, it indicates a sideways market. This often means that the number of buyers and sellers are equal. This market should only be traded in using swing highs and lows as entry points.

   

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Crossovers

You will often see traders using multiple moving averages at once. This is usually to spot crossovers which can result to entry signals and strong trends.

When using two or more moving averages the biggest MA crossing beneath the two smaller ones can signal a bullish reversal. This is simply due to the reason that a larger MA represents a long-term trend. When it crosses below smaller moving averages, it suggests that the recent price is becoming more bullish opening areas for buying opportunities. The opposite should be done when the biggest MA moves to the top as it means the trend has recently shifted to the decline.

Traders often add different moving averages while using the crossover strategy. A common and responsive sequence is the 13EMA, 21EMA, and 55EMA. The following scenario shows it being used in a real market.

Moving averages are a reliable addition for trendy markets although they often have a very late response causing the price to reverse back soon after an entry signal. This causes this indicators to give many false signals:

The 55EMA crosses over and under the smaller averages multiple times with little to no change. Due to late responses moving averages turn out to be useless is consolidating markets. Furthermore, MA crossovers shouldn't be used as the only indication while trading as they don’t represent market conditions and long term trends.

MACD (Moving Average Convergence Divergence):

The Basics

The MACD indicator is one of the most complicated momentum indicators and the favorite of many investors. The main use of MACD is to help investors identify strong entry points. This indicator consists of three main components: The MACD line, the signal line and the histogram.

The Components in Depth

The Signal line represents the 9EMA. It is usually plotted over the MACD line and can be a helpful tool to spot reversals.

The MACD line is calculated from subtracting the 26EMA from the 12EMA; so if the difference of these two values is a positive number the MACD line will be above zero. This signals good market conditions. On the other hand if the difference results in a negative number the line will slip below zero signaling a down-trend.

The Histogram shows the distance between the MACD line and the signal line. When the MACD line is above the signal line green bars are formed and when its below the signal line red bars are formed. The length of the bar portrays the strength of the trend. Long bars indicate strong trends, short bars indicate weak trends. The gradient of the bars can also represent the direction of the market. Multiple light bars mean the trend is dying out.

Identifying Entry Points

The MACD indicator can be much quicker at spotting reversals in compassion to moving averages. Although MACD will also form crossovers in small price changes (under 2%).

The Histogram is mainly used to identify trends in the market. When the chart shows engulfing dark bars it can signal strong entry points and a trend with strong momentum. The gap from one bar to another should gradually be increasing; if the gap starts to decrease in distance it can indicate loss of momentum and even a possible reversal. After significant buying pressure it is is common for the buyers to reach their “take profit”. When this level is reached sellers begin to dominate and the color of the bars can turn into a lighter gradient or the gap between dark bars can began to close off.

Histograms can often start to make many false calls when the market begins to move sideways. To avoid this it is best to stay out of trades when the histogram is surfing the 0 line.

The MACD line and the Signal line are used to spot reversals. This usually happens when the two lines cross through one another or through the 0 mark. These lines can also be used to spot support and resistance areas.

If the lines continuously bounces back up after reaching a certain point this area can be marked as a support zone. This place is used to spot dying trends as whenever the price reaches here buyers put more pressure into the market. The same analogy can be used to form resistance areas as sellers begin to put more pressure when the lines reach their swing-high. This strategy doesn't reflect the area in which the price immediately bounces back, rather the signal a reversal is approaching.

Immediate entry points are formed when the MACD line crosses with the Signal line. This method is only effective in extremely trendy markets. This means the price must make big moves in a very short time frame. Trading safe with MACD means to only secure buy entry's when both lines are either at or below the 0 mark. On the other hand, only secure sell entry's when both lines are either at or above the 0 mark.

When the MACD line crosses above the Signal line it is an area to buy. When the MACD line crosses below the Signal line it is an area to sell.

Although, this method can sometimes results in small success rates when the market is unstable, which causes price to drop back soon after crossing. A safter option can be to set a buy entry when the MACD line crosses the 0 mark which often results in a confirmed profit.

Divergences In MACD

Divergences occurs when the price and the indicator are not in agreement (indicating reversal).

This is an example of a bullish divergence. The chart clearly shoes a “lower low”, while the MACD line reads a “higher high”. The shape of these two lines forms an inclosing wedge and this divergence causes a big uptrend.

This is an example of a bearish divergence. The chart clearly shoes a “higher high”, while the MACD line reads a “lower low”. The shape of these two lines forms an outward wedge and this divergence causes a big downtrend.

RSI (Relative Strength Index):

The Basics

The Relative Strength Index measures the strength and speed of a trend. It can be very useful to spot big movements in price like reversals. It works by measuring the speed and change, orchestrating this amount in a scale from 0 to 100. It swing back and forth between this scale symbolizing 0–30 is an oversold area and 70–100 as an overbought area. 30–70 is considered the normal zone and the price remains in this area for 90% of the time.

The Over bought zone represents: amount of shares being purchased are extremely higher than the average. This means the amount of buyers in the market has increased severely. This creates an unstable market and can result in a heavy bearish trend. The same anogly is used in the Over sold zone. It indicates sellers have been dominating the market. This causes a high demand of buyers resulting in a bullish reversal.

Using this logic, traders would obviously be setting sell orders in the over bought region and buy orders in the over sold region. While this strategy can often be very profitable, it isn't always the case! The price of a share can remain in these zones for extended periods of times, indicating extremely powerful trend pressure.

Crossovers

When using RSI crossovers are usually accurate even if it results in small price movements. Similar to the other two indicators, the trendier the market, the more accurate the indictor.

Crossovers using RSI are extremely simple. When the moving average crosses above the RSI line it sets a sell indication. When the moving average crosses below the RSI line it sets a buy indication. It’s highly recommended to only enter trades when the chart and indicator both show tall swing highs and short swing lows.

Divergences In RSI

In traders eyes RSI is the best tool to spot divergence patterns. To recap; divergences occur when the chart and indicator are not in agreement. Divergences can be both bullish and bearish. They often tend to represent longer term movements (1–5 weeks).

To spot divergences consider using the “RSI Divergence Indicator” rather than the standard. This indicator has an accurate reorganization of divergences. The length of the divergence line correlates with the strength of the reversal. Be aware that divergences in RSI and MACD are exactly the same, its just easier to spot them using RSI.

This is an example of a bullish divergence. The chart shoes a “lower low”, while the RSI line reads a “higher high”. The shape of these two lines forms an inclosing wedge and this divergence causes a big uptrend.

This is an example of a bearish divergence. The chart clearly shoes a “higher high”, while the RSI line reads a “lower low”. The shape of these two lines forms an outward wedge and this divergence causes a big downtrend.