Momentum Trading Strategy - How That Works

People who had a chance to observe the behaviour of prices in the financial markets should have noticed that the power of trends is different. Momentum Trading Strategy is based on the idea that if the previous change of the price had enough strength behind it, then the likelihood of the trend to continue in the same direction would rise.

Momentum is one of the key parameters to characterize the trend’s power in technical analysis. Even if the price action had a clear direction but the momentum was weak, the attractiveness of entering such a market would be low compared to a trend with higher strength on a different asset. Forex trading suggests minimizing possible losses and maximizing potential profits, - these are the conditions to get profitable performance. Therefore, the goal of the technical analysis is to find trends which have a higher potential for the price to change. This is why such a metric as momentum is needed.

But how traders measure the momentum? This post is aimed to provide an in-depth guide on how to use momentum-based Strategies in Forex trading.

What is momentum trading?

Momentum Trading is a strategy consisted of several methods to analyse the market conditions in the scope of trend’s strength, make profitable trading decisions based on power factor and lower risks related to sudden changes in price movements. In other words, momentum strategy suggests a higher exposure to the trading volume directed in assets which have a higher potential for a strong and sustainable trend.

How does momentum work?

Imagine an asset getting a sudden supportive factor for its price. For example, the Reserve Bank of New Zealand unexpectedly hiked the interest rates, increasing the attractiveness of the local currency compared to its peers. It’s understood that the exchange rate of the New Zealand dollar should soar versus the U.S. dollar, Euro, Japanese yen and other major currencies with stable interest rates. Forex traders who noted this shift in the market’s sentiment would rush to join the new trend, adding the demand for the currency. This flow of speculative positions will add the buying pressure, while the sellers will be forced to retreat as quotes will rise sharply. The absence of short-sellers and additional volume of buyers rushing to enter the market at any available price would cause a spike in momentum, increasing the strength of the bullish action. As a result, such currency pairs as NZD/USD and NZD/JPY will soar even more rapidly, while EUR/NZD will plunge.

Key points of analysis

Typically, the momentum strategy does not focus on determining exact reversal points. The main goal is to benefit the main body of the trend. In other words, the momentum-based approach is keen on following the majority of traders in the foreign exchange market. However, the only source of information about the demand/supply ratio, besides the fundamental analysis, is the price chart. Therefore, the target is to develop a set of technical instruments based on mathematical formulas to identify trends with strong momentum, taking into account previous price action. Technical analysts developed several ways to identify mathematical metrics describing the market momentum. Those factors allowed setting a background of creating effective and reliable momentum trading indicators. Before we will have a closer look at the most popular among them, we should explain how the math works.

Mathematical background of momentum

There are four main approaches to identify momentum: correlation between moving averages, relative strength, standard deviation and average true range. We won’t bother readers with exact mathematical formulas and step-by-step calculations here. However, a basic understanding of each method would help build a profitable trading strategy based on momentum indicators.

Moving averages reflect the price change and they move together with prices. The distance between the current price and the moving average determines how powerful the trend is. At the same time moving averages with different periods could be placed closer or farther from the rates. During sustainable trend moving averages are placed in order of growing periods. Fast MAs with a lower period will be placed above lower MAs with a longer period during an uptrend and Vice a Versa. However, if the order is changed and one MA is crossing the other, a shift of the technical sentiment happens. The correlation of moving averages with different periods has a direct influence on momentum cycles.

Relative Strength is a parameter based on the calculation of average gain compared to the average loss. In case if an asset price keeps increasing the gain in the given period compared to previous gains, while the average loss is small or absent, then the bullish momentum is in play. The value of the price change is the main factor influencing the momentum, so relative strength is an important metric.

Standard Deviation measures prices’ volatility. The faster prices change and the farther they deviate from average values, the higher volatility is. At the same time, there is no strong momentum without high volatility as these two metrics come together in the sense of profitability in Forex trading.

Average True Range has a similar approach to calculating deviations from average prices. The only difference is that it uses several layers of smoothing. The aim is to cut rare whipsaws of the price, which come out of the general line. When prices go out of the ATR, the momentum is getting stronger.

If you like this strategy, you might also be interested in this London Daybreak Strategy

How to start momentum trading?

Momentum trading Forex applications might be different. Nevertheless, before starting the trading process, traders should develop personal rules of the investment strategy, set financial goals and determine risk management conditions. After that, traders should select the list of assets they are interested to trade on. For example, currency pairs, stock indices, commodities or cryptos. All of those asset classes have own features in terms of trading volume, volatility ranges, liquidity and vulnerability to the technical analysis. Therefore, the level of stop-loss and take-profit orders, as well as affordable profit/loss ratio will also differ.

Next, Forex traders should choose the main timeframe they want to trade on. There are dozens of different approaches in the scope of how frequent trades want to enter the market, how long are they keen on holding trading positions, do they want to focus on catching strong trends but ignoring insignificant fluctuations and so on. For example, momentum day trading strategy is focused on rare deals with the average time of 3-8 days in the market. It’s understood that this technique will be entirely different from intraday trading or scalping.

Depending on the choices above, traders can move on to choosing momentum indicators.

Momentum indicators

Coming back to the mathematical background, momentum indicators were created on four key approaches to measure the strength of a trend.

Here are some of the most popular ones:

  1. MACD: Moving Average Convergence and Divergence. The indicator uses exponential moving averages with different periods and correlations between them. This is a powerful momentum-based trend indicator with quite rare but reliable signals;
  2. Ichimoku Cloud is another version of how moving averages are used to find powerful trends, show directions and calculate the possible depth of retracements;
  3. RSI: Relative Strength Index. This is an oscillator having the relation between average gain to an average loss in the mathematical formula. This is an extremely popular indicator with multi-purpose functions and flexible applications. RSI is often used together with MACD;
  4. BB: Bollinger Bands. The envelope or channel indicator reflects the volatility and shows support and resistance levels on the price chart. The background of the indicator is Standard Deviation;
  5. ADX: Average Directional Index. With multi-level formula using Average True Ranges, the indicator shows two key metrics - momentum and surplus. The difference between -DI and +DI lines points to the trend’s direction.

Choosing the best momentum indicator for intraday trading is not as easy as different technical tools might or might not work precisely with a particular asset. For example, currency pairs with Japanese yen are related to Ichimoku Cloud, while such liquid pairs as EUR/USD could show a better performance with MACD and RSI. Every trading method has to be tested on a demo account before using it in real market conditions.

Examples of Momentum trading strategies

There are dozens of implementations of the momentum analysis in Forex trading. Momentum indicators can be combined in sets with other technical instruments with the purpose to increase the efficiency of a trading method and lower the number of false signals. The main advantage of momentum-based indicators that they cut and filter unnecessary market noise, lowering the overall number of entries. Below are shown several examples of momentum trading strategies in action.

MACD and RSI

This is one of the most widely-used combinations of technical indicators in Forex trading. It shows reversals of the price, point to divergences when the momentum is getting weaker and signal counter-trend action wheen the trend exhausted. The screenshot below shows an example of MACD with RSI on the EUR/USD daily chart.

Examples of Momentum trading strategies

Bollinger Bands and Stochastic RSI

Bollinger Bands is a popular envelope indicator reflecting the volatility and showing support and resistance levels. However, BB might give false breakout signals. Stochastic RSI is used in this combination to filter fake entries and confirm or deny the signal coming from Bollinger Bands.

Bollinger Bands and Stochastic RSI
bollinger bands and stochastic rsi gbp

Conclusion

Momentum trading strategy is a powerful instrument in the hands of a forex trader. The method is based on determining strong trends when the price action can bring the maximum profit. With several mathematical methods of determining the momentum and multi-purpose functional, the trading system is one of the most widely-used approaches in Forex trading. Many reliable and effective combinations of technical indicators allow traders to have a flexible set of must-have tools to trade successfully on any asset and any timeframe.

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