My top three favourite momentum indicators for systematic momentum investing

In an earlier video , I had explained what is momentum investing and the three types of momentum a stock can exhibit

1. Upward momentum

2. Downward momentum

3. No momentum (side ways movement)

In this article we will discuss about my top 3 favourite momentum indicators, the formula for calculating the values and some of the advantages and disadvantages of these momentum indicators.

I will also explain how some general interpretation of values and names can be misleading for beginner investors or traders.

• Rate of Change (ROC)

• Relative Strength Index (RSI)

• Commodity Channel index

Rate of change (ROC)

As the name says it measure the rate at which the price is changing.

Formula

Advantage of ROC:

Simple and straightforward calculation.

Clear view of price acceleration.

Disadvantage of ROC:

Sensitive to sudden huge price spikes.

Relative Strength Index (RSI)

One of the most popular momentum indicators among traders.

RSI compares the average number of higher closes to lower closes over a given period ( Default is 14 in most charting softwares like tradingview).

RSI oscillates between 0 and 100.

General interpretation of RSI is that

Greater than or Equal to 70 = Overbought

Less than or Equal to 30 = Oversold

This interpretation can mislead beginner investors, because the labels are misleading.

When beginners look at overbought and oversold names, they think that overbought region means it is not the right time to buy the stock and that oversold region means it is not the right time to sell the stock.

It is quite the opposite.

Stock enters overbought region because of the flow of large sums of money from big investors (smart money) who are ready to pay the premium prices and are not letting the price fall.

Remember that markets are always forward looking.

Smart money believes that the stock will be worth much more in the future.

Similarly, stocks enter into oversold region because the smart money wants to get out of the stock. When there is uncertainty about the future growth prospects of a company, investors rush to exit.

When smart money starts selling, the selling pressure drives the momentum in downward direction and the stock enters oversold region.

Also remember that stocks can remain in overbought and oversold region for quite some time.

Advantage of RSI:

Simple and easy to understand formula.

Easy to interpret ( > 70 and < 30 )

Disadvantage:

Slight lag (delay) in highly volatile market conditions.

Commodity Channel index(CCI)

CCI measures the deviation of the current price from its average price over a specified period.

It is an unbounded oscillator - it doesn’t have boundaries like in RSI.

Formula

General interpretation is

+100 means overbought

-100 means oversold.

Just like RSI, this general interpretation is misleading.

Advantages of CCI:

Easy to calculate.

Identifies both trend and momentum.

Disadvantage of CCI:

Sensitive to sudden price changes just like ROC.

Apart from ROC, RSI and CCI, there are several other momentum indicators like MACD, ADX etc.

Remember that all of them are measuring the same attribute of the stock price - MOMENTUM i.e they are measuring the direction and magnitude with which a stock price is moving.