Most traders prefer to try and catch a turning point in the market; most are not comfortable buying at high levels or selling at low levels. Ironically, these are the areas that have a high probability of trading success.
Momentum trading is a style of trading which focuses on currency pairs that are moving significantly in a particular direction with high liquidity.
Wikipedia defines momentum as "prices continuing to trend".
Webster's dictionary defines momentum as " the strength or force gained by motion or through the development of events".
So essentially, momentum refers to rapid movement or speed. In the same vein, momentum traders are traders looking for currency markets that are showing swift movements in price; and they take positions in the direction of the trend, with the hope that the momentum will continue in the trend direction.
There are two groups of momentum traders;
- There are those who trade using indicators that show price momentum
- The other group trade using the momentum that occurs from economic events and economic release of data. These group are called event-based momentum traders. Events such as Interest rate statements, speeches from the central banks regarding monetary policies, release of key data regarding economic development. These events are generally accompanied by very aggressive price movements.
There is a momentum indicator used by a lot of traders to measure and gauge price momentum. The indicator remains positive when the market is bullish and in an uptrend, while it turns negative when the markets are in a down trend and bearish.
The traditional approach using this indicator is to sell when the indicator goes below zero, and buy when the indicator goes above the zero line.
An example can be seen below on the USDJPY one-hour chart.
There are several other momentum indicators that can be used; some of the popular ones include MACD, CCI, RSI, STOCH, RVI and many more.
With this type of trading style, a trader is looking to trade when price momentum is high (periods of high volatility) and trade in the direction of the trend. These periods of high volatility can sometimes be found around market open or market close.
A momentum trader is looking for a currency pair that is volatile and trending; the trader is not particularly interested in why the currency pair is moving, but is only interested in taking advantage of the momentum of those price movements.
One of the key factors behind high volatility is high volume, so the momentum trader is always watching reaction of price movements to available volume.
There are momentum traders that trade using only volume as their decision-maker. They take positions when volume is high, and the market is trending. They are also quick to close out their positions when trading volume decreases. The logic behind this is that significant price movements can not happen without sufficient trading volume.
Resistance and support levels are also areas keenly watched by momentum traders, because high volume is required for price to breach strong resistance or support levels.
The momentum trader is essentially a swing trader, looking for ways to take advantage of trending markets.
A momentum trader will only trigger a position if it is support by momentum. If there is a trend but the momentum indicator does not support the trend, the momentum trader stays out of the market.
One of the great advantages of momentum trading is that the trader is not required to have any previous knowledge about the currency pair being traded; rather emphasis is on being able to determine when volatility is high and the current direction of the trend. This style of trading requires a lot of discipline and planning.
In a lot of cases, momentum traders are seen to buy at new high points in price; this is because price requires a lot of momentum to make a new high.
The trading process can be divided into four steps:
- Analyzing market charts: This is the point where the momentum trader is scanning through the charts, looking for currency pairs to trade. The pairs that meet the trading criteria are those that are trending, with very rapid price movements. As soon as the momentum trader identifies these trending and volatile pairs, the next step is to determine which direction the market is trending. The trend can be established using a simple moving average.
- Entry Decisions: Once the trend has been determined, the next step is trade entry. This part is crucial, because the momentum trader wants to get into the market when the momentum is very high, and hope that the momentum will carry his or her trade into reasonable profit. Some momentum traders restrict their trading to the first and last hour of a trading session to try and maximize the high volatility that occurs within those periods. It is a very effective tool for viewing bullish and bearish momentum.
3. Holding Positions: Momentum trading requires a lot of discipline and attention. A momentum trader usually trades one or two pairs, to avoid being distracted by monitoring several markets. Once a trade has been executed, the momentum trader is continuously watching the markets; to ensure that momentum is still on the side of the trade. What the trader is also looking out for is what is generally referred to as the saturation point, it is the point at which a bull or bear trend starts to lose momentum. At this point in a bull trend, the number of sell orders start to out-number the number of buy orders.
At a saturation area, the previous trend begins to falter loses its momentum. This could signal one of two things; either consolidation before the trend resumes or a change of trend direction.
4. Exiting Decisions: Momentum traders do not hold positions for extended periods. They exit their positions as soon as it stops being supported by momentum. Most of these traders happen during a trading day or a trading session. This does not mean they are scalpers, on the contrary they try to take advantage of day-to-day volatility in the Forex markets. A purely based indicator-approach could be using the DMI crossovers for all trade entries and exits.
It looks almost too easy, but sometimes the best solution can be staring at you in the face. This is an indicator I have applied in the strategy contest, and so far it has be doing very well.
I hope this article has been helpful, comments and thoughts on the subject matter are very much welcome.