Keep an eye on Momentum

One of the key principles of technical analysis is that price often lies, but momentum generally tells the truth. Just as professional poker players play the player and not the cards, professional traders trade momentum rather than price. In forex (FX), a robust momentum model can be a valuable tool for trading, but traders often struggle with the question of which type of model to use. Here we look at how you can design a simple and effective momentum model in FX using the moving average convergence-divergence (MACD) histogram.

Why Momentum?

First, we need to look at why momentum is so important to trading. A good way to understand the importance of momentum is to step completely outside the financial markets and look at an asset class that has experienced rising prices for a very long time—housing. House prices are measured in two ways: month-to-month increases and year-to-year increases. If home prices in New York were higher in November than in October, we could safely conclude that demand for housing remained solid and that further increases were likely.

However, if prices suddenly fell in November from prices paid in October, especially after rising relentlessly for most of the year, then this may provide the first clue to a possible change in trend. Of course, house prices will most likely still be higher in a year-over-year comparison, leading the general public to believe that the real estate market is still buoyant. However, real estate experts, well aware that housing weakness manifests much earlier in month-on-month figures than in year-on-year data, will be much more reluctant to buy under those conditions.

In real estate, month-to-month figures provide a measure of the rate of change, which is what the study of momentum is all about. Just like their counterparts in the real estate market, professionals in the financial markets will keep a closer eye on momentum than they do on price to determine the true direction of a move.

Use the MACD histogram to measure momentum

Rate of change can be measured in a variety of ways in technical analysis; a relative strength index (RSI), a commodity channel index (CCI) or a stochastic oscillator can all be used to measure momentum. However, for the purposes of this story, the MACD histogram is the technical indicator of choice.

First invented by Gerald Appel in the 1960s, the MACD is one of the simplest, yet most effective, technical indicators around. When used in FX, it simply records the difference between the 12-period exponential moving average (EMA) and the 26-period exponential moving average of a currency pair. In addition, a nine-period EMA of MACD itself is plotted next to the MACD and serves as a trigger line. When MACD crosses the nine-period line from below, it indicates a change to the upside; when the move happens in the opposite way, a bearish signal is made.

This oscillation of the MACD around the nine-period line was first plotted in a histogram format by Thomas Aspray in 1986 and became known as the MACD histogram. Although the histogram is in fact a derivative of a derivative, it can be deadly accurate as a potential guide to price direction. Here is one way to design a simple momentum model in FX using the MACD histogram.

1. The first and most important step is to define a MACD segment. For a long position, a MACD segment is simply the full cycle made by the MACD histogram from the initial break of the 0 line from the bottom to the final collapse through the 0 line from the top. For a short, the rules are simply reversed. Figure 1 shows an example of a MACD segment in the EUR/USD currency pair.

2. After noting the previous high (or low) in the preceding segment, you can use that value to construct the model. Moving on to Figure 2, we can see that the preceding MACD high was .0027. If the MACD histogram now registers a downward reading whose absolute value exceeds 0.0027, then we will know that downward momentum has exceeded upward momentum, and we will conclude that the current setup presents a high probability discount.

3. Once the MACD segment is established, you should measure the value of the highest bar within that segment to record the momentum reference point. In the case of a short, the process is simply reversed.

If the case is reversed and the preceding MACD segment was negative, then a positive reading in the current segment that exceeds the lowest low of the previous segment would then indicate a high probability long.

What is the logic behind this idea? The basic premise is that momentum as indicated by the MACD histogram can provide clues to the underlying direction of the market. Using the assumption that momentum precedes price, the thesis of the setup is simply this: a new swing high in momentum should lead to a new swing high in price, and vice versa.\

Let’s think about why this makes sense. A new momentum swing low or high is usually created when price makes a sudden and violent move in one direction. What causes such price action? A belief by either bulls or bears that price at current levels represents excessive value, and therefore strong profit opportunity. Typically, these are the early buyers or sellers, and they would not act so quickly if they did not believe that the price was going to make a significant move in that direction. Generally, it pays to follow their lead, as this group often represents the “smart money crowd.”

While this setup may offer a high probability of success, it is by no means a guaranteed money-making opportunity. Not only will the setup sometimes fail outright by producing false signals, but it can also generate a losing trade even if the signal is accurate. Remember that while momentum indicates a strong presence of trend, it provides no measure of its ultimate potential.

In other words, we can be relatively certain of the direction of the shift, but not of its amplitude. As with most trading setups, successfully using the momentum model is much more a matter of art than science.

Look at entry strategies

A trader can use several different entry strategies with the momentum model. The simplest is to go long or short a market when the model flashes a buy or sell signal. This can work, but it often forces the trader to enter at the most inopportune time, as the signal is typically produced at the absolute top or bottom of the price burst. Prices may continue further in the direction of the trade, but it is much more likely that they will return and that the trader will have a better entry opportunity if they just wait. Figure 3 demonstrates one such entry strategy.

Sometimes the price will reverse against the directional signal to a much greater extent than expected, and yet the momentum signal will remain valid. In that case, some skilled traders will add to their positions – a practice some traders have jokingly called “SHADDing” (for “short addition”) or “LADDing” (for “long addition”). For the novice trader, this can be a very dangerous maneuver – there is a possibility that you could end up adding to a bad trade and thus compounding your losses, which could be disastrous. However, experienced traders know how to successfully “fight the band” if they see that the price presents a significant deviation from momentum.

Placing stops and limits

The final matter to consider is where to place stops or limits in such a setup. Again, there are no absolute answers, and each trader should experiment on a demo account to determine his or her own risk and reward criteria. This author places his stop at the opposite 1 standard deviation Bollinger Band® setup away from his entry, as he feels that if the price pulled back against his position by such a large amount, the setup will most likely fail. In terms of profit targets, some traders like to book profits very quickly, although more patient traders can reap much greater rewards if the trade develops a strong directional movement.

The Bottom Line

Traders often say that the best trade may be the one you don’t take. One of the greatest strengths of the momentum model is that it does not engage in low-probability setups. Traders can fall prey to the impulse to try to catch every turn or movement of the currency pair. The momentum model effectively inhibits such destructive behavior by keeping the trader away from the market when the countermomentum is too strong.

As Kenny Rogers once sang in “The Gambler,” “You knew when to hold ’em, [and] know when to fold them.” In trading, as in poker, this is the true skill of the game. The simple momentum model we’ve described here is one tool that we hope will help forex traders improve their trade selection process and make smarter choices.