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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 an invaluable tool for trading, but traders often grapple with the question of what type of model to use.
First, we need to look at why momentum is so important to trading. A good way to understand the significance of momentum is to step outside of the financial markets altogether 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-over-month increases and year-over-year increases. If house prices in New York were higher in November than in October, then we could safely conclude that demand for housing remained firm and further increases were likely.
However, if prices in November suddenly declined from prices paid in October, especially after relentlessly rising for most of the year, then that might provide the first clue to a possible change of trend. Sure, house prices would most likely still be higher in a year-over-year comparison, lulling the general public into believing that the real estate market was still buoyant.
However, real estate professionals, who are well aware that weakness in housing manifests itself far earlier in month-over-month figures than in year-over-year data, would be far more reluctant to buy under those conditions. In real estate, month-over-month figures provide a measure of rate of change , which is what the study of momentum is all about. Much 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 ascertain the true direction of a move.
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 gauge momentum. However, for the purposes of this story, the MACD histogram is the technical indicator of choice. First invented by Gerald Appel in the s, the MACD is one of the simplest, yet most effective, technical indicators around.
When used in FX, it simply records the difference between the period exponential moving average EMA and the period exponential moving average of a currency pair. When MACD crosses the nine-period line from the bottom, it signifies a change to the upside; when the move happens in the opposite manner, a downside signal is made.
Although the histogram is in fact a derivative of a derivative, it can be deadly accurate as a potential guide to price direction. 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 breach of the 0 line from the underside to the final collapse through the 0 line from the topside. For a short, the rules are simply reversed. Having noted the prior high or low in the preceding segment, you can then use that value to construct the model.
If the MACD histogram now registers a downward reading whose absolute value exceeds 0. Once the MACD segment is established, you need to measure the value of the highest bar within that segment to record the momentum reference point. In case of a short, the process is simply reversed. If the case were reversed and the preceding MACD segment were negative, a positive reading in the present segment that would exceed the lowest low of the prior segment would then signal a high probability long.
What is the logic behind this idea? The basic premise is that momentum as signified 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 precipitates such price action? A belief by either bulls or bears that price at present levels represents inordinate value, and therefore strong profit opportunity. Typically, these are the early buyers or sellers, and they wouldn't be acting so quickly if they didn't believe that price was going to make a substantive move in that direction.
Generally, it pays to follow their lead because this group often represents the "smart money crowd. However, although this set-up may indeed 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 may be relatively certain of the direction of the move, but not of its amplitude. As with most trading setups, the successful use of the momentum model is much more a matter of art than science. A trader can employ several different entry strategies with the momentum model. The simplest is to take a market long or market short when the model flashes a buy or a sell signal.
This may 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's far more likely that they will retrace and that the trader will have a better entry opportunity if they simply wait.
Before joining Forbes Advisor, John was a senior writer at Acorns and editor at market research group Corporate Insight. Select Region. United States. United Kingdom. Anna-Louise Jackson, John Schmidt. Contributor, Editor. Editorial Note: We earn a commission from partner links on Forbes Advisor. Commissions do not affect our editors' opinions or evaluations. What Is Forex Trading? Featured Partner Offer. Limited Time Offer. Trade in a variety of assets including stocks, ETFs and cryptocurrencies.
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In forex (FX), a robust momentum model can be an invaluable tool for trading, but traders often grapple with the question of what type of model to use. The forex market runs on the normal business hours of four different parts of the world and their respective time zones. The U.S./London markets overlap (8 a.m. Here are the secrets to winning forex trading that will enable you to master the complexities of the forex market. The forex market is the largest market in.