Learn how to make more profitable trades with this trade entry technique.

What is momentum?

Momentum measures the rate of changes in asset prices. In its simplest form, momentum is calculated as:

Current momentum = Current price – Past price (x days ago)

Usually momentum follows price, rising and falling as price rises and falls. However, on occasion there can be divergence, where a price makes a new high or low, and the momentum does not.

Some common momentum indicators include Momentum, RSI, Stochastic and Price Rate of Change (RoC).

What is divergence?

Divergence involves measuring the change in the value of an asset in relation to the change in value of an indicator, index or other related asset. Divergence is when the price of the two move in opposite directions – positive divergence is when the price of an asset makes a new low while the indicator starts to rise, and negative divergence is when the price of the asset makes a new high as the indicator starts to fall.

How do momentum and divergence help my trading?

Momentum and divergence form a trade entry technique known as momentum divergence trading. Momentum divergence trading uses the rate of change in an asset’s price to determine when to enter a trade. This can be either in an established trend, or range bound markets.

When a price and momentum diverge, this can signal a change in price direction.

Figure 1: Australia 200

If we examine Figure 1, the top half of the chart shows the value of the Australia 200 between November 2010 and June 2011. The bottom half shows the RoC indicator, or the momentum. Lines 1, 2 and 3 show normal market and momentum movement, with the momentum following the value of the Australia 200.

However, line 4 shows market divergence, with the Australia 200 climbing to a new high, and momentum starting to fall. This is a bearish divergence – a signal that the market is going to fall and a warning for traders to go short. The signal to enter the trade is when the indicator has passed its lowest point for that period. Referring to Figure 1, the indicator hit its lowest point of the period on April 9th 2011. Following this, the market reached a new high, while the indicator did not make a new high, showing divergence. The entry signal occurred on April 12th 2011 when the indicator passed the April 9th low.

Following the signal, you can enter the trade short with a stop above the most recent high point. As there is no take profit target with this trade, you can run a trailing stop, or monitor the trade for when the market starts to trade sideways or move against you.

In May, line 5 shows a second market divergence. Although the market has hit a new low, the indicator has not, and has started to climb – this is a bullish divergence, and perhaps a warning of an impending signal to go long.

It’s important to note that the signal to enter the trade had not been triggered at the time of writing. Although momentum divergence trading is an excellent tool for planning entries to the market, it’s important not to act as soon as divergence starts, but to wait for the entry signal.

Like the signal to go short was when the indicator moved below its low point for the period, the signal to go long would be when the indicator rose above its high point for the period, which has not occurred in Figure 1.

Momentum divergence trading can be a good method for determining future market directions and, if traders wait for the signals to enter and exit their trades, it can help them make high probability trading decisions.

When can I use momentum divergence trading?

Momentum divergence trading can be used across a wide range of financial markets, including CFDs, shares, stock indices, commodities, binaries, options and more.

This information has been prepared by IG Markets Limited (ABN 84 099 019 851) (AFSL 220440). No representation or warranty is given as to the accuracy or completeness of the above information, consequently any person acting on it does so entirely at his or her own risk. IG Markets accepts no responsibility for any use that may be made of these comments and for any consequences that result.