What is Forex Momentum Trading? A Beginner's Guide

Overview

1. What is Momentum Trading？

2. Key Factors of Momentum Trading

3. Popular Momentum Trading Indicators

4. Best Momentum Trading Strategies

5. How to Trade Momentum in the Forex Market？

6. Pros & Cons of Momentum Trading

7. Conclusion

1. What is Momentum Trading？

The first thing we need to understand is what momentum actually is. Momentum is the strength of a trend in its literal sense. The momentum trading strategy involves opening trades only in the direction of strong price trends, taking advantage of the continual price movement, and exiting before the trend reverses.

Momentum traders don't usually worry about where trends end and begin, but rather focus on opportunities within the trend body. This mindset may lead traders to “buy high and sell high.”

Despite following short-term trends, momentum trading is not to be confused with trend trading, which refers to long-term trades. Momentum traders pay close attention to short-term fundamentals, but trend trading only applies to macro asset classes.

Trading momentum refers to a market's ability to maintain its price direction, increasing and then decreasing as price trends grow, slow, and eventually reverse.

2. Key Factors of Momentum Trading

1) Volume

A volume refers to how many assets are traded in a given period of time. There must be a steady flow of buyers and sellers in the markets in order for momentum traders to enter and exit the trade quickly.

2) Volatility

In financial markets, volatility refers to the tendency for prices to rise or fall rapidly within short periods. To profit from short-term fluctuations in asset values, momentum traders must find volatile markets.

3) Time Frame

Trading strategies based on momentum rely heavily on short-term market movements, such as day trading and scalping. The duration of the trade, however, depends on how long the trend remains strong. Momentum traders also focus on long-term trading, such as position trading, in addition to short-term trading.

3. Popular Momentum Trading Indicators

The three most commonly-used indicators for momentum trading are Relative Strength Index (RSI), Moving Average Convergence Divergence (MACD) and Stochastic Oscillator.

As opposed to many free momentum trading strategies that use only one indicator, advanced momentum trading strategies typically use a combination of two or more indicators. Long-term traders can use momentum day trading strategies as well as momentum day trading strategies.

Let's learn a little more about these three common momentum trading indicators.

1) Relative Strength Index (RSI)

The Relative Strength Index (RSI) indicator was created by J. Welles Wilder and is famous as a momentum oscillator. This indicator measures the change and speed of price movements, oscillating between 0 and 100.

As with other range-bound indicators, this indicator provides overbought and oversold signals based on its value. The market is considered overbought when trading is above 70 and oversold when trading is below 30.

It is important to remember that just because the RSI provides overbought and oversold signals, it does not necessarily mean the trend is going to reverse.

The basic formula for the indicator is as follows:

RSI = 100 – [100 / ( 1 + (Average of Upward Price Change / Average of Downward Price Change ) ) ]

2) MACD

The Moving Average Convergence Divergence (MACD) is a well-known technical analysis indicator that is used for momentum trading as well as other strategies that rely on technical analysis.

MACD identifies price movements by using three exponential moving averages. A histogram shows the difference between these averages, which can indicate whether a trend is strengthening or weakening.

In spite of this, moving averages always lag behind price action, which is why momentum traders should use the MACD to determine entry points - since they enter after the trend starts anyway - but may want to use another indicator to determine exit points.

3) Stochastic Oscillator

Based on the most recent closing price and the previous trading range, the Stochastic Oscillator compares the price over a specified time period. Instead of following price or volume, this indicator tracks the underlying market's speed and momentum.

As a leading indicator, the stochastic is excellent for exiting momentum trades because it predicts price movements. On a price chart, it consists of two lines: the indicator line and the signal line.

The indicator line: A range-bound line oscillates between 0 and 100. An overbought reading over 80 indicates an oversold market, and a reading below 20 indicates an oversold market.

The signal line: Overbought or oversold crossovers of the signal line and indicator line indicate that the price is going to reverse, and traders can buy or sell accordingly.

4. Best Momentum Trading Strategies

The best way to learn momentum trading is to start with a free demo account, which offers riskless virtual capital.

Momentum strategies are designed to identify the strength of price movements in order to determine whether others will be attracted to them and therefore create some momentum (as discussed in the second section).

For example, Volume indicators may be used in momentum trading on stocks and shares. It is most common to use a forex momentum trading strategy since the forex market is open 24 hours a day and there are so many algorithmic trading robots that contribute to creating momentum trends.

Combining two of the most popular momentum indicators can help traders build a potential strategy. If you are considering implementing any strategies or tools, demo accounts are the best way to determine their effectiveness. Trading can bring both psychological gains and losses, so it's a good idea to learn to cope with both.

An Example of Strategy Idea:

Long: RSI (3) is oversold if the price is above the 20-period exponential moving average.

Short: RSI (3) is overbought if the price is below the 20-period exponential moving average.

Markets and time frames with clear short-term trends are the best for momentum strategies.Trading with the trend and momentum often adds confluence to your trading setup, however, there is always the risk that the trend may bend and reverse.

5. How to Trade Momentum in the Forex Market？

The forex market operates 24 hours a day and is volatile enough to cause some large moves. Volatility offers many trading opportunities and momentum trades can be found. You can also be in and out of your positions quickly and at very low costs.

In the forex market, you can trade from an abundance of forex pairs when you trade momentum. You don't want to be stuck watching one pair or one-time frame because you want to find the strongest moving markets and time frames. There are many different forex pairs and time frames available, from monthly charts to one-minute charts, on the forex market.

Please remember that moves in the forex markets can be explosive when using momentum trading strategies. It is important to practice strict money management controls. Always set tight stop loss levels and determine how much you are prepared to lose before entering any trade.

6. Pros & Cons of Momentum Trading

As shown in the above table, the pros of momentum trading clearly outweigh the cons. In spite of that, it is still important to back-test every strategy and understand the risks associated with it.

7. Conclusion

The bottom line is that momentum trading can be highly profitable if done correctly. It is likely that many traders will use the strategies discussed in this article and combine them with their favourite tools and techniques to find high-probability entry points. The strategies include using Japanese Candlesticks, price action clues to confirm breakouts or other favourite indicators.

Bear in mind that always test any new strategies, systems, or indicators on a free demo account or virtual charts before putting real money on the line.

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