Technical Analysis 101 with Stocks Down Under: Momentum Indicators

Marc Kennis, July 12, 2022

Momentum indicators in technical analysis are used to measure the direction and magnitude of price movements. Steeper and longer price swings represent stronger momentum and shallow slope and short price swings represent weaker momentum. Momentum indicators quantify price movements’ strength and make comparisons between different price movements possible.

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Relative Strength Index (RSI) and Moving Average Convergence Divergence (MACD) are two of the most popular momentum indicators amongst technical analysts. You can always find them in the bottom of our stock charts in our technical analysis insights articles.

Relative Strength Index (RSI)

The RSI indicator shows the relative size of gains in the price versus losses over a given period, usually 14 days. RSI uses a smoothing function in its formula to return readings only between 0 and 100, the higher the reading, the more bullish the momentum in the price is and vice versa.

An RSI reading above 70 indicates an overbought condition and it’s a sign that buyers have bid the price up too quickly and increases the chances of corrective pullbacks in the price.

On the other hand, an RSI reading below 30 indicates an oversold condition and it’s a sign that sellers have bid the price down too fast. It increases the chances of a price reversal or corrections in the price.

Moving Average Convergence Divergence (MACD)

The MACD indicator consists of two lines, the MACD line and the MACD signal. On the default setting, the MACD line is calculated by subtracting the 26-day exponential moving average (EMA) from the 12-day EMA. The MACD signal is a 9-day EMA of the calculated MACD line.

Too complicated? Don’t worry. This is what you need to know:

A MACD line above both zero and the MACD signal is a sign of bullish sentiment on the stock. A MACD line crossing below the MACD signal would be an initial sign of a potential trend reversal. If the MACD line continues downwards and crosses below zero as well, then we can say that the sentiment on the stock has shifted from bullish to bearish.

The opposite is also true. A MACD line below both zero and MACD signal is a sign of bearish sentiment on the stock. But a MACD line crossing above the MACD signal would be a sign of potential emerging bullish sentiment on the stock. If the MACD line keeps ascending to cross above zero as well, then the indicator is telling us that the sentiment on the stock has shifted from bearish to bullish.

You can find the RSI and MACD indicators in the bottom of the following chart.

Select Harvest (ASX: SHV), Daily Chart in Semi-log Scale (Source: Metastock)

❶ MACD line crosses below MACD signal, at the same time that the uptrend breaks.

❷ MACD line crosses below zero as well, signalling bearish sentiment on the stock.

❸ MACD line crosses above MACD signal, at about the same time as the 5-day EMA crossing above the 20-day EMA.

❹ MACD line crosses above zero as well, shortly before the downtrend breaks.

❺ Price makes higher highs but the RSI fails to make higher highs, indicating price-momentum divergence at the end of the uptrend.

❻ Price makes lower lows but the RSI makes higher lows, indicating price-momentum divergence at the end of the downtrend.

Notice how different indicators confirmed each other with some small differences in timing. It is always a good idea to wait to see confirmation amongst different indicators to obtain more certainty on the shift in sentiment.

Momentum Divergence

When momentum indicators disagree with the share price, a divergence has occurred. We normally use RSI as the momentum indicator for finding divergences. In an uptrend a divergence has occurred when the price makes a higher high, but RSI does not. It is a sign that the bulls are running out of steam.

This, however, by itself does not grant a trend reversal, but it is an early indicator and has important implications for trade management, such as taking partial profits or being more cautious when deciding to buy once the price retraces to the trendline. Point 5 on the Select Harvest chart shows an instance of a momentum divergence in an uptrend.

In a downtrend, a momentum divergence has occurred when the price makes a lower low, but RSI does not, and it’s sign that the bears are losing their enthusiasm to sell. This can be a sign for a temporary pause in the selling pressure or the beginning of a more significant shift in sentiment.

After detecting a momentum divergence, we can begin to monitor the other technical patterns and indicators that we have so far introduced you to in previous Technical Analysis articles (trendlines and moving averages, price action, MACD, …) for an early detection of a reversal in the trend.

Markets don’t always trend

It is important to note that signals from basically all technical indicators are the most reliable when the price is trending up or down and that they are less reliable in range trading and during choppy markets. Historically markets only trend about 30% of the time. Therefore, it is important to familiarise yourself with the price behaviour during ranging and choppy markets and the implications for making trading and investment decisions.

In our next Technical Analysis 101 article, we are going to discuss price patterns that are common to form in range markets and we’ll show you how to find them and use them for forecasting the next move in the price.