How to Use Momentum Indicators

Upbeat music plays throughout.

Narrator: In the world of investing, momentum is the concept that a stock's current price trend will continue. In other words, a trend in motion tends to stay in motion. Investors can apply this concept in an attempt to profit from rising stock prices and reduce losses from falling stock prices.

To accomplish this, investors can use the momentum indicator to measure a stock's momentum up or down.

In this video, we'll show you what the momentum indicator is, how it can help investors identify potential entry and exit signals, and discuss some of its risks.

The momentum indicator measures the rate of change in a stock's price over time. This might sound complex, but it's really quite simple.

Animation: A person is tossing a ball up and letting it come back down to their hand.

Narrator: Think about what happens when you toss a ball in the air. After you throw the ball, it moves fast. But as the ball climbs higher, its upward momentum slows. Eventually, the ball stops, and then starts to drop. As it falls, the ball gains downward momentum and increases speed before returning to you.

Animation: The ball appears next to a stock graph and rises and falls with the stock price. Below the price graph is an indicator measuring momentum.

Narrator: Similarly with stock, price, the momentum of a stock's trend slows before it changes direction. The momentum indicator measures the rate of change in a stock's price.

Investors can calculate momentum by measuring price differences over a specific time period. For example, a 10-day momentum indicator is calculated by subtracting the closing price of 10 days ago from the current closing price. The indicator then plots this value as a line on the stock chart.

So, if today's price is the same as it was 10 days ago, the indicator plots at the zero line. But if today's price is higher, the indicator plots above the zero line. And if today's price is lower than 10 days ago, the indicator plots below the zero line.

When the indicator crosses the zero line, some investors might consider this a possible entry or exit signal.

On-screen text: Disclosure: For illustrative purposes only. Not a recommendation of any security or strategy.

Narrator: Let's look at an example. Say an investor enters a position when the momentum indicator crosses above the zero line. He would then possibly hold the position as long as the indicator stays above zero. When the indicator crosses below the zero line, the investor might take that as an exit signal.

While this example trade may have been profitable, not all crossover points are reliable entry or exit signals.

This is because the momentum indicator can generate numerous signals as it crosses above and below the zero line.

On-screen text: A bulleted list includes Applying price patterns and Examining the overall trend of the market.

Narrator: To help reduce the number of entry and exit signals, consider using additional conditions as a filter. Such filters include applying price patterns or examining the overall trend of the broader stock market.

For example, some investors might only consider an entry signal valid if the broader market is trending higher. Conversely, some investors might only consider an exit signal if the broader market is trending lower.

Using a filter might help reduce the noise that too many signals can cause.

Animation: A graph of transaction costs versus. time has two lines titled "Filtered" and "Unfiltered." The Unfiltered line is growing faster than the "Filtered" line.

Narrator: Additionally, filters can reduce the transaction costs of buying and selling on every momentum indicator.

Momentum is a widely used concept in investing and can be measured with indicators like the momentum indicator. If you're going to apply it, be careful to avoid overtrading and consider using filters, such as high volume or price patterns.

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