When it comes to technical trading strategy, one of the most important factors is momentum.
This is the theory that when a price has some momentum behind it, it is really hard for that momentum to turn.
This is why traders often make the statement that “the trend is your friend”. Traders are always trying to find trends and spot those that have the most momentum behind them.
When there is positive momentum behind a price movement, this builds on itself and tends to snowball forming some sort of a chain reaction.
There is no doubt that to succeed as a trader, you have to make use of one of the most powerful drivers of returns.
In the below post, we will take a look at 5 of the top momentum trading strategies and how you can make use of them to effectively profit from trends.
What is a Momentum Strategy?
In essence, a momentum trading strategy will place a trade in the direction of the trend for an asset that is showing positive momentum.
This can be on the upside and on the downside. The trader is of the view that the rest of the market is also trying to catch the trend and will hence make it a self fulfilling prophecy.
A slowdown in momentum is also a good indicator of when a trader should exit a trade and realise a profit.
This is based on the assertion that prices in the previous period impact on the price in the current period.
Indeed, there are opposing theories such as the random walk theory which asserts that all prices follow a completely random trajectory.
This has been widely debunked in practice.
If the random walk theory was indeed based in any fact, then there would not be any traders that were able to make a profit from trading.
If you want to follow any sort of momentum trading strategy, you have to know all of the best tools. We will run over some of the key momentum indicators which inform trading.
Top Indicators of Momentum
Although many people can easily understand what momentum is, it is slightly harder to spot an asset with momentum.
This is because although an asset may be increasing in price, there is no one “metric” that someone can use as they benchmark for this “momentum”.
There are, however, a number of indicators and oscillators that have been used for a very long time which are indicative of momentum.
This is one of the most important indicators of momentum.
Volume is the amount of trades taking place within a particular period of time. It is the amount of money that is changing hands.
This is indicative of momentum as it shows that there are a large amount of people who are selling and buying the asset.
Hence, when a trader sees that there is increasing volume, this is indicative of possible momentum in the underlying.
Another reason that momentum is such an important indicator is because it is used as an input in a number of other momentum indicators such as the On Balance Volume and Money Flow Index which we will cover below.
On Balance Volume
The On Balance Volume indicator (OBV) incorporates volume as a predictive force in the price of the asset. It is based on the premise that when volume increases without large movements in price then the price will eventually jump.
The OBV is a cumulative volume indicator that increases when there are up days and will decrease when there are down days.
When there is an up day, the volume on that day is added to the volume of the previous day. When there is a down day the volume is then subtracted.
The interpretation of the OBV is that it could possibly give an indication of building pressure on a price even though the price remains relatively static.
Even if the price is merely inching up but there is a lot of volume, the OBV will be increasing at a substantial rate.
The reasoning behind this is the difference between “smart” institutional investors and your retail investors.
The intuitional investors may be buying the asset as the retail investors are selling when the OBV is increasing but the price is relatively flat.
This is a sign of positive momentum in the asset price and is a bullish sign.
Relative Strength Index
RSI = 100 – 100/(1 + RS)
RS = Average Gain / Average Loss
The Relative Strength Index (RSI) is another indicator which is extremely useful when it comes to momentum trading strategies.
RSI is an “oscillator” which means that it will oscillate between two extremes and is used as a benchmark to determine oversold or overbought assets.
It is an indicator that measures the speed of change in the underlying asset. The rule of thumb for the trader to identify the oversold and overbought levels is 70 and 30 respectively.
Hence, when interpreting the RSI indicator, the trader will be cautious when an asset is either oversold or overbought as it could be indicative of a possible reversal of trend and slowdown in momentum.
There are a number of momentum trading strategies that can be employed only by using the RSI, yet the astute trader should always combine his indicators.
Money Flow Index
Average Price = (High + Low + Close)/3
Raw Money Flow = Average Price x Volume
Money Flow Ratio = (14-period Positive Money Flow)/(14-period Negative Money Flow)
Money Flow Index = 100 – 100/(1 + Money Flow Ratio)
The Money Flow Index (MFI) is an indicator that combines volume and the RSI in one handy indicator.
Many people usually term the MFI as the volume weighted RSI. The trader will first get a “raw” money flow and then use the RSI formula to create an oscillator of it.
The interpretation of the MFI is similar to that of the RSI. It is used to identify any potential reversals from price extremes.
The oversold and overbought levels for the MFI are 20 and 80 respectively and is seen by many as slightly more predictive than the RSI.
This is because the MFI includes volume which many people believe is indeed predictive of certain price pressures.
Traders could also create a number of different momentum trading strategies that incorporate any divergences between the asset price and the MFI.
Moving Average Convergence
MACD Line: (12 Period EMA – 26 Period EMA)
Signal Line: 9 Period EMA of MACD Line
Histogram: MACD Line – Signal Line
The moving average convergence / divergence (MACD) is another momentum indicator that is a staple tool on the chart of nearly all technical analysts.
This indicator combines the information that one is usually able to garner from the standard moving average trend lines into one comprehensive chart.
The MACD is calculated as the difference between two EMA (Exponential Moving Average) lines. One of the lines will be the “short” EMA and one will be the “long”.
When the MACD is positive, this is usually sign of bullish momentum because the short term EMA is above the long term EMA.
When plotting the MACD, the trader will also take a look at the EMA of the MACD itself (the signal line). This will enable the trader to spot any possible reversals of the MACD and hence momentum.
The Histogram in the MACD is calculated by taking the difference between the MACD indicator itself and the signal line.
When the MACD is above the signal indicator then the histogram is positive and the converse is seen when it is below. We have covered MACD trading strategies previously in more detail.
Top 4 Momentum Trading Strategies
Now that you have an idea of the best indicators that one has at their disposal for spotting momentum, we will take a look at some of the most effective strategies that you can employ.
The FXaxe traders have compiled this list of strategies after having tested them on a range of assets including Forex, Commodities, Equities and Crypto.
Make sure that your trading platform has all of the indicators above as standard as these are essential in order to implement these strategies.
It is also advisable to plot the charts with candlestick price ticks. We have previously covered a range of candlestick strategies that one should be aware of before trading.
1. Increasing Volume
This is probably one of the simplest yet fundamental indicators of momentum. Nearly all technicians are of the view that volume is a necessary requirement for momentum to take hold.
The theory is that when an asset is trending in a particular direction with increasing volume this is likely to continue and feed on itself.
In the below image, we have the price of Crude Oil in USD plotted on a candlestick chart with 4 hour ticks. We have also plotted the 20 and 50 period EMA in order to give an indication of trends.
As one can see above, there was a turn in the price of Oil on Thursday the tenth. Volume was increasing substantially so this means that momentum was increasing on the downside.
If the trader had entered a short position on Oil on that Thursday then the trader would have made a profit on the fall of oil.
On Friday, there was also an indication of increasing volume on a positive trend. This was a bullish indicator and the trader would have made a profit on the increasing price.
2. Diverging Oscillator
This occurs when there is a divergence in the price of the trend of the asset and some oscillator. This is usually seen as an indicator that the momentum in the trend may be tapering.
The trader could use either the MFI or the RSI as the indicator when looking at a possible divergence. The divergence also is much more pointed when it is either above or below the overbought / oversold point.
Taking a look at an example, below we have the EURUSD chart that is plotted with 15 minute candles.
As you can see, when the pair started trading on Monday morning, the price was trending upwards. Yet, the RSI indicator was overbought and trending downwards.
This was a divergence and was an indication that the momentum in the price of the asset was declining. Hence, the trader should have seen this as a possible indication of reversal.
In this case, the trader should be wary about entering a long position in the asset. The price of EURUSD did indeed reverse itself trend lower after that.
This is a prime example of why a lack of momentum can tell a trader that a particular trend is “running out of steam” and is likely to reverse.
3. MACD 0 Crossover
As mentioned, the MACD is one of the most useful momentum based indicators. When the MACD changes from positive to negative, this is a sign that the momentum has reversed.
Traders will carefully watch for opportunities of possible trend reversal around these 0 line crossovers. Also, when the MACD is hovering around 0, this means that there is no momentum and the trader should hold off placing any trades.
In the chart below, we have USD/JPY plotted with 2 hour candlestick with EMA trend lines as well as the MACD indicators that are plotted below.
As you can see from the image above, the MACD is the difference between the short EMA (12 period) and the long EMA (26 period). The blue line is the MACD indicator and the red line is the signal line.
The MACD crossed over from negative to positive. This was a bullish indicator and shows that the momentum went from negative to positive.
This bullish crossover could also have been predicted by the bullish signal crossover earlier (explained later). The trader should enter a long position in USD/JPY and the trader would have made a handsome profit.
4. MACD Signal Crossover
There is also another crossover of significance when looking at the MACD and that is the signal line crossover. Traders look at is as an indication that the momentum is slowing.
This is mainly by taking a look at the momentum in the MACD indicator itself. What the trader is looking for is situations when the MACD will crossover the signal line.
This is termed a “signal line” crossover and is an indication that momentum could be changing one way or another. When the MACD crosses the signal line from the top then this is a “bearish” crossover. When it crosses from the bottom then it is a bullish crossover.
Taking a look at an example, below we have the price of Ether in USD that is plotted on a 15 minute candlestick chart as well.
In the chart, you can see that the MACD line crosses over the signal line from the top and is hence a bearish MACD crossover. This is an indicator that the positive momentum that was present appears to be tapering off.
This is indeed a bearish sign and the trader should take the opportunity to short the price of Ether. If the trader had held his position then he would have seen his opportunity to exit a bit later on a Bullish crossover.
This bullish crossover was an indication that momentum was indeed turning and the asset was about to increase in price.