If you think of Forex trading as a poker game, you will quickly discover that a currency’s price should not be the final factor for your decision to buy, sell, or hold.
Professional poker players generally play the player, not the cards. In the same way, professional traders rely on indicators and momentum, rather than price, to optimise their trades.
Momentum trading measures the strength of an existing trend by showing the rate of price movement changes over a specified time period. Applying the idea of momentum, this technique makes use of the strength of the latest price trends to help you decide when to buy or sell.
Momentum trading suggests that if the price is forced towards a certain direction, either uptrend or downtrend, this will likely continue for some time. In essence, you trade by betting on an asset price that’s moving strongly in a specified direction and its ability to persist in that direction until that strength fades. There are two categories of momentum trading that you traders must understand:
1. Relative momentum strategy
In this classification, the performance of various securities under one asset class is determined so you can compare a security’s performance to another’s. Traders normally buy good-performing securities while selling those with weak performances.
2. Absolute momentum strategy
By employing absolute momentum, only one security is involved in the technical analysis. The price behaviour is compared against its past performance in a defined time series.
How does a momentum strategy work in Forex?
Either absolute or relative momentum strategy can work for you but trading strategies are inclined to use absolute momentum. Momentum can be calculated within hours or minutes of Forex trading sessions or over a longer period of time such as months or weeks. Technical analysts typically compute momentum under a 10-day time frame. The calculation is done using the formula below:
Momentum = V – Vx
where V is the current price,
Vx is the closing price at x,
and x as a specific number of days ago
For a momentum strategy to work, there are four steps that must be undertaken:
- Identify the trend direction that you’ll be using.
- Establish an entry point of buying or selling using available momentum indicators.
- Set an exit point based on past and forecasted support and resistance levels.
- Identify stop-loss orders below or above your trade entry point as your defence against unexpected reversals or changes.
Overall, you ought to buy securities that are rising and sell them when they reach their peak.
What are momentum indicators?
Determining an asset momentum is easier with the use of momentum indicators. As Forex trading goes on, the price movement velocity arrives at a maximum point when the entry of money or new traders in a particular trade reaches its peak. The price may flatten or reverse after reaching a peak when less potential new investment is present.
Momentum indicators fall into different types, and there are nine categories we must look into:
- Moving averages
- Relative Strength Index (RSI)
- Moving Average Convergence Divergence (MACD)
- Commodity Channel Index (CCI)
- On Balance Volume (OBV)
- Stochastic Momentum Index (SMI)
- Average Directional Index (ADX; and
- Building block
With its track record in generating profitable trades, momentum is a valuable key concept that is helpful in devising both short- and long-term trading strategies.
You must remember, though, that the basis for calculating momentum are price trends in the past and the actual price and momentum may deviate, as triggering events may not be considered in the original calculations. It is always wise to set preventive measures to be ready for market volatility.