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When markets are bullish, strong momentum can carry them much higher than anyone expects. When markets turn south, they do so shockingly fast. And that’s why it’s so important to know how to measure market momentum. You don’t want to leave yourself exposed to heavy losses.

First, let’s talk about why momentum is so important. Money flowing into the markets carry them higher. The more days and weeks the money is flowing, the higher the markets go. Sure, eventually the money runs out. By then, the markets have pushed higher than anyone expects, and probably irrationally higher. Remember what Maynard Keynes said 100 years ago: “Markets can stay irrational longer than you can remain solvent.”

How to measure market momentum

Relative strength index

The relative strength index (RSI) is one of the most reliable technical tools; I have used it for years. It shows you how a particular stock is doing price-wise versus an index. It was developed by famed technician Welles Wilder to measure the speed and change of price movements. If you believe that momentum continues once it’s established like I do, then the RSI is your tool.

When I’m looking at the RSI, I look for higher lows and higher highs over 14 periods and an embedded reading that stays above 70 for a while.

MACD

The MACD (moving average convergence/divergence) identifies changes in a stock’s or index’s trajectory before it actually happens. I use the standard 12-26-9 setting and look for crossovers on the histogram. Whether the momentum is up or down, this tool is valuable in helping to identify a new trend before it happens.

Stochastics

Stochastic indicators are the most accurate and reliable technical tools for determining timing. Stochastics measure the relationship between a security’s closing price and its price range over a set timeframe. These indicators are easy to read, as they show when price action hits overbought and oversold levels.

An oversold stock reads above the 80 levels – time to sell! And undersold stock is below the 20 level – time to buy!

Price action

Price action is the king of the indicators. I never make a trading decision unless price action backs up what the other indicators are saying. I suggest you monitor price action along with these momentum tools to help determine your next move.

When markets are on fire, as they have been, keep a close eye on the MACD. When it starts to falter, you may want to start selling positions.

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