Momentum indicators are the wingman of the trend, and as the trend is your friend in Forex, so, momentum indicators are also your friends. Why?
Have you ever thought that a rally extension shouldn’t work, yet the price escalates levels and reaches new records every moment? Well, the momentum indicator tells you about that.
Today, we are going to talk about one of the best technical indicators in the Forex world. Think that every trading book always has a chapter explaining momentum because authors acknowledge it as a cornerstone for investing. However, what is momentum?
What is Momentum
Momentum is a physics term which tries to measure the mass and velocity of an object or a unit. In Forex, and investing, Momentum is a leading indicator which measures the pair rate of change. In other words, the velocity that the pair moves in either direction, up or down.
Momentum Indicator, or MOM, compares the current price with the previous value of the unit in a given number of periods in the past. Its graphical form is expressed as an oscillator with no lower or upper limit.
The implications for a bullish or bearish movement come after interpretations of divergences, lines movements, crosses, and extreme numbers.
When you know the velocity of price change, you will have clues about when the pair is moving strong and when the rally is coming to an end. Long story short, Momentum give you the rate of the rise or decline in Forex pairs.
That being said, statistic studies show that Momentum is more accurate, thus useful, in rising markets than declining pairs.
How Is Momentum indicator calculated?
As Momentum is the measurement of the speed of change in a pair, also known as velocity, you only have to watch for previous prices and compare it with the current price. However, not that easy. Let’s see.
Forex Momentum is measured by taking price differences for a given time interval. Let’s built a 20-day momentum line. From a Previous period, please subtract the closing price 20 days ago from the last closing price. The value, positive or negative, is plotted around a zero line that will be used as a reference.
CP=The latest price
CPx=The closing price x number of days ago
If you are a trend trader, Momentum Indicator will be one of your best friends as it shows the strength or weakness in current prices.
How to trade with Momentum Indicator
Momentum investing is the art of making trading decisions based on the health of a trend and the bet of its continuance. Momentum traders believe that trends persist for some time, and it is possible to cash out from price continuation until the pattern comes to an end.
Traders who do Momentum investing has a strict set of rules based on the MOM plus other technical indicators to identify entry and exit points as well as stop losses. The momentum indicator is often used as a confirmation tool.
There are three basic Momentum strategies, the 100 line cross, the crossover, and the divergence. Let’s talk about it.
100 line cross: Measuring Momentum
The 100 line, or the zero line, is significant when it comes to talking about Momentum. It is all about when the price crosses above or below the 100 line and it shows buying or selling signals.
If the price goes above the 100 level, it shows that the pair is gaining Momentum. Also, when it drops below the 100 line, it shows the pair is losing Momentum. Sometimes, prices hesitate about breaks, so, to avoid false breaks, you may want to filter signals based on the current trend.
A filter can be that when a pair is rallying, if a pair is trending higher, buy only when the indicator falls below the 100 line and then it surges back above it. On the other hand, if the pair is falling, go short on the cross only when it drops back below the 100 line.
Crossover: The dance of moving averages
One of the most popular Momentum strategies includes the use of two long-term moving average. Remember that moving average is the average closing price over a giving number of previous periods.
Buy when the smaller moving average crosses above the bigger one. For example, the 50 and 200-day moving averages, when the 50-day MA crosses above the 200 days, it creates a buying signal. On the other hand, when the 50-day MA goes below the 200-day moving average, it is a selling signal.
The best option to avoid “whipsaw” is only to go when the pair is in the trend direction. Also, please test different period lengths and momentum indicators settings to find the best combination for your trading style.
Divergence: The ultimate confirmation
Divergence shows differences between the current trend and the health of that movement. A bullish divergence happens when the pair is moving lower, but the lows on the momentum indicators are moving higher. The interpretation says that while the price is falling, the selling momentum is slowing.
On the other hand, if the pair is going higher, but the highs of the momentum indicator are moving lower it is a bearish divergence. In other words, while the price is rising the stamina behind the movement is fading.
Divergence is an excellent tool for confirmation of other signals. However, it shouldn’t be used as a trading signal on its own.
Note that sometimes when the pair rises sharply but then moves sideways or in consolidation, the momentum indicator will rise and then start dropping. Don’t read it as a weak signal, it is just replicating what is happening in the chart, but it doesn’t mean that the price will drop.