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Trading the Momentum Indicator

Trading the Momentum Indicator

Crypto Technical Analysis

13 Nov 2020

With the Momentum Indicator, we can calculate the acceleration of an asset’s price, by measuring the speed at which the price is changing.

Part of the family of oscillators, the Momentum Indicator is one of the most popular tools for many crypto traders. Technical indicators in the oscillator family range between two extreme values that generate trading signals about crypto markets being overbought or oversold. Next to the Momentum Indicator, oscillators include the Money Flow Index (MFI), Relative Strength Index (RSI), Rate of Change (ROC), and Stochastic Oscillator.

Structure of the Momentum Indicator

With the Momentum Indicator, we can calculate the acceleration of an asset’s price, by measuring the speed at which the price is changing. This market momentum is measured by continually taking price differences at a fixed time interval. To construct a momentum line, we subtract the closing price of the first day from the closing price of the last day. The negative or positive value is then plotted around a zero line.

The formula for calculating the Momentum Indicator
M= V−Vx

V= The latest price
Vx= The closing price x number of days ago

On most charting tools available on crypto exchange, you can set the value to which the momentum will compare the current closing price, with 10 and 14 days as the most common time period.

Trading the Momentum Indicator on the crypto markets

Crypto traders use the Momentum indicator in a few different ways. Generally speaking, this comes down to 3 different trading approaches.

1. Riding the Trend

The simplest way to use this indicator, is to follow the trajectory of the Momentum line. In the Bitcoin price chart below, you can see how this looks when a Momentum Indicator with a value of 10 is applied.

In this price chart, we see the price action creating a short-term bottom as the Momentum line hits the lowest levels which then recovers along the way as the BTC price action recovers. The Momentum Indicator here confirms that the market conditions are changing from bearish to bullish, which creates trading opportunities for short-term crypto traders.

2. Trading Extremes

Opposite to the previous trading strategy, you can use the Momentum indicator to buy low and sell high. In fact, this is quite similar to using the RSI for trading oversold and overbought conditions in crypto markets.

BTC/USD price chart – Trading Extremes with the Momentum Indicator

​We use the Momentum Indicator in such a way that it provides extreme readings on both sides, drawing two lines. In the BTC price chart above, any reading above +400 or below -400 indicates the market is trading in extreme conditions and a reversal is in the cards.

However, it should be understood that when a market is oversold, a reversal is not guaranteed. That’s why indicators should always be used in combination with another technical indicator.

3. Divergence

Because of the way they are designed, divergence can occur in almost all oscillator indicators.

For the Momentum Indicator, bullish divergence occurs when the price action creates lower lows but the Momentum indicator does the opposite making higher lows. This means market momentum is strengthening and the price could soon move upwards to catch up with the Momentum indicator.

Conversely, a bearish divergence occurs when prices are making a higher high, but the Momentum indicator creates lower highs. Although there is a bullish attitude on the market, the discrepancy means that market momentum is slowing. In this case, it’s likely that there will be a decline in price.

Indicated in the BTC price chart below, we see Bitcoin’s price reaching higher lows for some time, while the Momentum Indicator creates a new low, diverging from the trajectory of the price action. The bearish divergence that occurred here indicated a sell signal.

BTC/USD price chart – Divergence with the Momentum Indicator - Divergence

Are you ready to put your skills to the test?

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