Equity investing: Using momentum indicators to invest in stocks

By Hemanth Gorur 

While technical indicators of stock price movements like moving averages and support and resistance levels can help identify trends in the stock markets, frequently this is not enough. These trend indicators do not forewarn investors before a trigger event occurs upon which the investor needs to take action. Often, what is required is to gauge the momentum of a particular trend or stock price movement. Investors can deploy the momentum indicators outlined below to do just that.

Moving Average Convergence Divergence (MACD)
The MACD indicator uses the simple fact that when a shorter-term moving average of a stock price crosses above a longer-term moving average, then the stock price has been rising faster recently than it was in the past, indicating an impending uptrend. On the other hand, if the shorter-term moving average crosses below the longer-term moving average, it indicates an impending downtrend.

The shorter-term and longer-term term moving averages can be set to any periods respectively based on the analysis required. For investment purposes, these can be the 100-day Exponential Moving Average (EMA) and the 200-day EMA respectively, or the 50-day EMA and 100-day EMA, respectively.

The MACD then is calculated simply as the difference of the two moving averages.
MACD = shorter-term moving average – longer-term moving average

How to detect stock price momentum using MACD
When the MACD is positive, the shorter-term moving average is higher than the longer-term moving average. As long as the MACD is positive and keeps increasing (or “diverging” from zero), it indicates rising momentum and thus an uptrend.This is a “buy” sign.

When the MACD is positive and starts decreasing (or “converging” towards zero), it indicates that the shorter-term moving average is rising at a lower rate than the longer-term moving average, thus signaling a falling momentum and thus a downtrend. This is a “sell” sign.

When it hits zero from either direction, it signals a trend reversal, from uptrend to downtrend or vice versa. When the MACD is negative and keeps diverging from zero, it indicates a falling momentum. When negative and converging towards zero, the MACD signals rising momentum.

Relative Strength Index (RSI)
The Relative Strength Index (RSI) is another momentum indicator that is helpful in gauging stock price momentum in terms of whether the stock is overbought or oversold. It makes use of the up closes and down closes of the stock price.

An “up close” is when the stock price closes higher than its close on the previous trading day. A “down close”, similarly, is when the stock price closes lower than its previous close. The RSI makes use of a series of consecutive up closes and down closes to indicate momentum.

RSI = 100 * (average of ‘x’ up closes) / (average of ‘x’ up closes + average of ‘x’ down closes)

If the average of ‘x’ number of up closes is around 70% of the sum of averages of ‘x’ number of up closes and ‘x’ number of down closes, then the stock is overbought. This can be a “sell” sign. If it is around 30%, then the stock is oversold. This can be a “buy” sign. That is, RSI values of 30 and 70 (or 20 and 80) are buying and selling opportunities respectively. In either case, it may be signaling a trend reversal.

An RSI value of 50 is said to indicate a support or resistance level, depending on whether the stock price is falling or rising. At this point, the averages of the up closes and down closes are equal or nearly equal. So the prevailing trend may continue.

Momentum indicators are usually used by day traders to detect buy or sell signs. But that doesn’t mean investors with long term plans cannot use them. With careful calibration of the periods used for deriving these indicators, investors also can detect long term buy or sell signs.

The writer is founder, Hermoneytalks.com

MOMENTUM CUES
Relative Strength Index (RSI) and Moving Average Convergence Divergence (MACD) are two useful momentum indicators

MACD is the difference of the shorter-term moving average over the longer-term moving average and helps detect an uptrend or downtrend

RSI gauges stock price momentum in terms of whether the stock is overbought or oversold