When the price of an asset and an indicator, index or other related asset move in opposite directions. In technical analysis, traders make transaction decisions by identifying situations of divergence, where the price of a stock and a set of relevant indicators, such as the money flow index (MFI), are moving in opposite directions.
Because trends are composed of a series of price swings, momentum plays a key role is assessing trend strength. As such, it is important to know when a trend is slowing down. Less momentum does not always lead to a reversal, but it does signal that something is changing, and that the trend may consolidate or reverse.
Price momentum refers to the direction and magnitude of price. Comparing price swings helps traders gain insight into price momentum. Here, we’ll take a look at how to evaluate price momentum and show you what divergence in momentum can tell you about the direction of a trend.
Defining Price Momentum
The magnitude of price momentum is measured by the length of short-term price swings. The beginning and end of each swing is established by structural price pivots, which form swing highs and lows. Strong momentum is exhibited by a steep slope and a long price swing. Weak momentum is seen with a shallow slope and short price swing
For example, the length of the upswings in an uptrend can be measured. Longer upswings suggest that the uptrend is showing increased momentum, or getting stronger. Shorter upswings signify weakening momentum and trend strength. Equal length upswings means the momentum remains the same. (For related reading, see Momentum Trading With Discipline and Riding The Momentum Investing Wave.)
Price swings are not always easy to evaluate with the naked eye – price can be choppy. Momentum indicators are commonly used to smooth out the price action and give a clearer picture. They allow the trader to compare the indicator swings to price swings, rather than having to compare price to price.
In technical analysis, divergence is considered either positive or negative, both of which are signals of major shifts in the direction of the price. Positive divergence occurs when the price of a security makes a new low while the indicator starts to climb upward. Negative divergence happens when the price of the security makes a new high, but the indicator fails to do the same and instead closes lower than the previous high.
Momentum Indicators
Common momentum indicators for measuring price movements include the relative strength index (RSI), stochastics and rate of change (ROC). Figure 2 is an example of how RSI is used to measure momentum. The default setting for RSI is 14. RSI has fixed boundaries with values ranging from 0-100.
For each upswing in price, there is a similar upswing in RSI. When price swings down, RSI also swings down
The study of momentum simply checks whether price and the indicator agree or disagree.
Conclusion
The most useful way to use a momentum indicator is to know what strategy to use. Price will lead the way but momentum can indicate a time to preserve profits. The skill of a professional trader lies in his or her ability to implement the correct strategy for price action.