To be a successful at day trading, you should learn as much as possible about the most effective rules and indicators. The momentum rule is a prime example. By understanding what it means and how to use it, you will have an easier time making profitable trades.
What is the Momentum Rule?
As someone who has been active in stock trading and investing, you should already be familiar with the significance of the zero line. Put simply, it represents the point at which the current price is the same as the price a certain number of days ago.
The zero line plays a crucial role in the momentum rule, which dictates that you should buy when the momentum indicator crosses above the zero line and sell when it dips below it. Why would you do that? When the momentum indicator rises above the zero line, it means the price is trending upward, so it’s a good time to buy. When the momentum indicator drops below the zero line, the price is trending downward, so you should sell.
Divergence and Momentum
Although the concept of momentum is simple enough to grasp, many traders are thrown off when divergence comes into play. On most charts, a line pointing upward represents an increase in value. However, with momentum, an upward line reflects the speed of a price change.
When analyzing a chart, remember that the price can increase while momentum drops. This is known as divergence. Basically, it occurs when momentum moves in the opposite direction of a price trend. Also, it is possible for momentum to move higher or lower but not to reach the same high or low as the previous peak or valley. Meanwhile, the price trend may be reaching a new high or low. In this instance, both momentum and price are moving in the same direction, but momentum doesn’t quite keep up with the movement of the price.
Recognizing Momentum on a Chart
Take a look at the figure on this page for a minute. As you can see, the price is reaching a new high. About midway through, though, it stops creating new highs and moves in the opposite direction. Shortly after that, it flattens out. Look at the momentum indicator. See how it crosses the buy/sell line immediately the following day? It’s a sure sign to buy or sell, which allows you to do so near the peak of the price movement.
Momentum typically peaks before the price does, which produces a divergence between the movement of the price and the movement of the momentum. This is a clear sign to buy or sell right away.
Using Momentum as a Confirmation Rule
Momentum is popularly used alone to detect buy and sell signals. It can also be used as a confirmation indicator. Under the confirmation rule, both indicators need to agree before a trade is made. It’s wise to do this for a few reasons. It reduces the number of whiplash trades, reduces the total number of trades and increases the odds of making profitable trades.
By having a firm grasp of momentum indicators and how they work, you can increase your success in the world of day trading. Study more examples to ensure that you recognize momentum indicators when they occur. By heeding them, you will have an easier time making profitable trades.