Stock Momentum Indicator: The Good vs. The Bad

Stock Momentum Indicators: Understanding What Works and What Doesn’t

Jan 11, 2025

Momentum indicators are the bread and butter of technical analysis, sought after by countless traders looking to gain an edge in the chaotic world of financial markets. These tools, often revered as the fortune-tellers of the stock market, aim to predict trends, measure strength, and identify reversals. But here’s the hard truth: some indicators work like precision instruments, while others are as useful as a broken compass. Some suck so badly that they resemble financial sewage, misleading traders and draining profits.

Understanding which indicators deserve your attention and should be relegated to the trash bin requires more than blind trust in their mathematical formulas. It combines mass psychology, common sense, and practical experience. Let’s delve into the world of momentum indicators, separate the wheat from the chaff, and explore what works, what doesn’t, and how to navigate this minefield with finesse.

The Role of Momentum Indicators in Trading

Momentum indicators are designed to measure the speed or strength of a price movement, helping traders determine whether a stock’s trend has more room to run or is losing steam. They are especially useful for timing entries and exits, capturing breakouts, or spotting reversals.

But here’s the catch: momentum indicators are not magic wands. They are tools, and like any tool, their effectiveness depends on how they’re used and the context in which they’re applied. Traders often misuse them, relying on them blindly without considering the broader picture, including mass psychology, market structure, and risk management. This is where stupidity kills profits.

The Squeeze Momentum Indicator: A Powerful Tool, If Used Correctly

The squeeze momentum indicator (SMI) is a more sophisticated and effective momentum indicator, provided you know how to wield it. Unlike many other indicators that simply track trends, the SMI combines volatility and momentum, giving traders a clearer picture of when a stock is gearing up for a big move.

Crafting a Plan Around the Squeeze Momentum Indicator

The squeeze momentum indicator identifies periods of low volatility—when Bollinger Bands contract inside Keltner Channels—and signalling when the price is about to “squeeze” into a breakout. This is visualized with a histogram that measures bullish or bearish momentum.

To use the SMI effectively, you need to focus on the key steps:

Identify the Squeeze

Scan for assets where Bollinger Bands have contracted within Keltner Channels. This visual contraction signals that price action is consolidating and that a breakout is imminent.

Evaluate Momentum Bias

Check whether the histogram bars are bullish (green) or bearish (red). Are they increasing in size, showing strength, or fading out, signalling weakness?

Combine with Secondary Indicators

The SMI rarely works well in isolation. Pair it with tools like MACD, RSI, or Ichimoku Cloud to confirm the breakout direction. For example, bullish momentum on the SMI is more reliable if the RSI shows strength or if the MACD has just crossed bullishly.

Plan Entries and Exits

Set logical entry points based on the SMI’s signals. For bullish setups, place a buy-stop order just above the distance. For bearish setups, use the reverse logic. Always define a stop-loss below the consolidation low to protect yourself.

Size Positions Wisely

SMI breakouts can lead to explosive moves but can also result in fakeouts. Use appropriate position sizing so a single bad trade doesn’t obliterate your portfolio.

React to False Signals

Not all squeezes lead to profitable outcomes. If a squeeze “fires” and momentum fizzles out, exit quickly. There’s no room for ego in trading; stubbornness is a quick ticket to losses.

The Flaws and Solutions

Even with its strengths, the SMI isn’t perfect. It can generate false signals, especially in choppy markets where volatility doesn’t lead to sustained trends. The SMI should be combined with mass psychology and common sense to address this.

Think about market participants: what are they doing during periods of low volatility? Often, they hesitate and are uncertain about the next move. This is why volume analysis is crucial—if the squeeze fires without a corresponding increase in volume, it’s likely a false breakout. Pairing the SMI with volume indicators or observing market sentiment can save you from unnecessary losses.

Other Momentum Indicators: Heroes and Villains

While the SMI is a standout tool, it’s not the only momentum indicator in town. Let’s explore some others and understand when they work when they don’t and how to avoid falling into traps.

RSI (Relative Strength Index)

The RSI is one of the most popular momentum indicators, measuring whether an asset is overbought or oversold. It ranges from 0 to 100, with readings above 70 indicating overbought conditions and below 30 signalling oversold conditions.

When It Works

RSI shines in ranging markets, helping traders spot reversals where the price is likely to bounce from overbought or oversold zones. It’s also useful for identifying divergences—when the RSI moves in the opposite direction of price, signalling potential trend reversals.

When It Doesn’t

RSI fails miserably in strong trending markets. For example, a stock in a powerful bullish trend can remain overbought for weeks or months, leaving traders who rely solely on RSI scratching their heads as the price continues to climb.

The Fix

Use RSI in conjunction with trend analysis. Treat overbought RSI as a sign of strength in a strong uptrend rather than a reversal signal. Similarly, in downtrends, oversold RSI levels often indicate momentum rather than a buying opportunity.

MACD (Moving Average Convergence Divergence)

The MACD is a trend-following momentum indicator that shows the relationship between two moving averages of a stock’s price.

When It Works

MACD is effective for spotting trend changes, especially when its signal line crosses above or below the MACD line. It’s also useful for confirming momentum in conjunction with other indicators like the SMI.

When It Doesn’t

MACD lags in sideways markets, generating whipsaw signals that can drain your account faster than you can say “stop-loss.”

The Fix

Filter MACD signals with broader market trends or use it as a secondary confirmation tool. For instance, only act on bullish MACD crossovers in an uptrend and bearish crossovers in a downtrend.

Stochastic Oscillator

The stochastic oscillator compares a stock’s closing price to its price range over a specific period, signalling overbought and oversold conditions.

When It Works

This indicator works well in range-bound markets, offering clear buy and sell signals when it crosses above or below certain thresholds.

When It Doesn’t

Like RSI, the stochastic oscillator is a disaster in trending markets, frequently giving premature reversal signals.

The Fix

Align the stochastic oscillator with the overall trend. In an uptrend, use oversold readings as buying opportunities. In a downtrend, use overbought readings to sell or short.

The Role of Mass Psychology in Momentum Indicators

Indicators are only as good as the market participants they reflect. Every candlestick, every indicator reading, and every breakout is the result of collective human behavior. Understanding mass psychology is critical to interpreting momentum indicators effectively.

When stocks consolidate, as seen in the SMI’s squeeze setups, traders sit on the sidelines, waiting for a cue. Fear and greed dominate their decision-making. A sudden breakout triggers a tidal wave of emotions—fear of missing out (FOMO) for those not yet in the trade and panic for those on the wrong side.

Momentum indicators like the SMI, RSI, and MACD attempt to quantify these emotional shifts. However, blindly following them without considering the emotional state of the market is akin to trying to navigate a battlefield with a map but no context.

Stupidity Kills Profits

Here’s a harsh reality: stupidity kills profits. Blindly trusting indicators without understanding their context is a recipe for disaster. Far too many traders treat momentum indicators as gospel, ignoring basic principles like trend analysis, volume confirmation, and risk management.

Common sense must prevail. Don’t assume that it’s guaranteed to work just because an indicator flashes a signal. Ask yourself:

– Does the signal align with the broader trend?

– Does volume confirm growing interest?

– Are there external factors, like earnings reports or macroeconomic events, that could derail the setup?

Failing to ask these questions is not just lazy—it’s suicidal.

Combining Momentum Indicators with Technical and Fundamental Analysis

Momentum indicators alone are rarely enough to ensure profitable trading. Combine them with technical and fundamental analysis for a more comprehensive approach. For example:

– Use the SMI to identify potential breakouts but confirm them with volume or price action.

– Pair RSI or MACD signals with support and resistance levels.

– Incorporate fundamental analysis—like earnings reports or sector trends—to gauge whether solid catalysts back a stock’s momentum.

Conclusion: The Art of Balancing Tools, Psychology, and Discipline

Momentum indicators are powerful tools, but they are not foolproof. Some, like the squeeze momentum indicator, excel in specific scenarios, while others, like the RSI or MACD, require careful application to avoid pitfalls.

The key to success lies in balancing these tools with mass psychology, common sense, and a solid trading plan. Understand the emotional state of the market, verify signals with secondary indicators, and always manage your risk.

Above all, remember this: stupidity kills profits. Blindly following indicators without context, ignoring broader trends, or failing to adapt to changing market conditions will erode your account.

Breaking Boundaries: Adventures in Thought

Stock Momentum Indicator: The Good vs. The Bad

Stock Momentum Indicators: Understanding What Works and What Doesn’t Jan 11, 2025 Momentum indicators are the bread and butter of ...