Momentum indicators in Forex are great for measuring the speed of prices over a specific period of time in order to get in and out of the trade at the right moment. You want to be able to get in when momentum is accelerating, indicating that traders have great confidence in the current trend. You want to be able to get out when momentum is decelerating, indicating uncertainty for traders as they re-evaluate the odds of chasing the price.
Trend indicators can identify the up or down trend and can tell you of a pending trend reversal, but they cannot tell you the moment of entry/exit as well as momentum. Momentum indicators can show you the best moment to make the trade, to buy or sell with the higher odds that the market will move in your favor. They can can also tell you when the momentum of the trend is weakening, and you can use this information to take profits or re-adjust your trailing stops.
Good examples of momentum indicators are Momentum, RSI, and Stochastics.
|Trend Indicator Relevance||Relevance|
|Momentum Indicator||The oldest (simplest) momentum indicator|
|RSI||The most popular momentum indicator|
|Stochastics||Second most popular momentum indicator|
All aspiring traders know the importance of momentum. There are numerous clichés that urge traders to go with the momentum. In the 1960s, the concept of rate of change (ROC), or momentum, became popular with traders, and this popularity has lasted up to today, though it has probably been unseated to some degree by other indicators. The Momentum indicator measures the amount (and speed) that a currency’s price has changed over a given time span, pieces of information that we can take advantage. Generally, strong trends reflect increasing momentum, whereas weakening trends reflect decreasing momentum. We will be discussing the original ROC momentum indicator, and not indicators commonly referred to as momentum indicators, such as Accumulative Swing Index (ASI), Advanced Decline Ratio (ADR), Aroon, Commodity Channel Index (CCI), Relative Strength Index (RSI), and Stochastics, all of which likewise track the speed of price change over time.
Let us look at the momentum indicator found in MT4 and how it can be profitably used.
Momentum is calculated as a ratio of today’s price to the price several periods ago (MomPeriod):
MomPeriod is the only variable one can customize, and it is defaulted at 14. For the sake of illustration, we will look at a daily chart of EURUSD with a MomPeriod = 5:
As you can see from the above chart, the current momentum is 101.33. How is this calculated? You are going to divide two closing prices: the current close (1.2394), divided by the close of 5 bars prior (1.2227), which gives us 1.0136; we then multiple 1.0136 with 100 to give us 101.36. Note that price had been travelling up, so our momentum value is above 100 or bullish; if price had been travelling down we would have had a momentum value less than 100 or bearish.
Momentum (5) = 1.2394 / 1.2227 *100 = 101.36
Three ways to use the Momentum indicator:
1. Momentum as a Trend-Following Oscillator (100 Line Pivot)
Bullish Signal is generated when the Momentum crosses above its 100 line and a bearish signal is generated when the Momentum crosses down the same line.
|Long Signal||Previous Momentum < 100
Current Momentum > 100
(Mom Crossing Over 100 from Below)
|Short Signal||Previous Momentum < 100
Current Momentum > 100
(Mom Crossing Under 100 from Above)
By itself, this strategy will tend to create too many signals to be profitable. It works best with other conditions or filters, such as the 20 SMA suggested by Alexander Elder (or any period MA deemed suitable via back testing). For instance, if the mom crosses over 100 from below, and the close is also above its 20 SMA, then a buy signal can be taken. Reverse for the sell signal.
I would also suggest optimizing the MomPeriod for the particular pair and time frame you want to work your system upon. There are maybe other periods more suitable than 14. The default of 14 was chosen to reduce the “noise” of a volatile market without losing much of its advantage.
2. Momentum as a Leading Indicator of Exhaustion and Trend Reversal
You can use the Momentum indicator as a trend-reversal indicator similar to RSI or Stochastics and their use of overbought/oversold levels. BUY when the indicator bottoms and turns up and SELL when the indicator peaks and turns down. As there are no overbought/oversold zones of 80/20 like RSI or Stochastics to determine possible bottoms or peaks, you instead have to test for different Overbought (OB) and Oversold (OS) levels that can work out, as in the table below:
|Long Signal||Previous Mom < 100 – OSLevel
Current Mom > 100 – OSLevel
(Crossing over 100 – OSLevel from below)
|Long Signal||Previous RSI < 100 + OBLevel
Current RSI > 100 + OBLevel
(Crossing under 100 + OBLevel from above)
Note: If the Momentum indicator reaches extremely high or low values (relative to its historical values), you should assume a continuation of the current trend. For example, if the Momentum indicator reaches extremely high values and then turns down, you should assume prices will probably go still higher. In either case, only trade after prices confirm the signal generated by the indicator (e.g., if prices peak and turn down, wait for prices to begin to fall before selling).
It is also a good idea to use the momentum indicator in conjunction with a 100 or 200 period moving average. You should buy and sell in the direction of the MA trend, as you can see in the EURUSD H1 chart below:
I have plotted each of these 4 red arrows to point out when momentum had reached relative low points (bottoms) and turned upwards in the direction of the main trend established by the 100 period moving average. If you had missed getting on board the MA direction when the price crossed above it, the bottoms of the momentum become nice alternative entry points.
3. Momentum as a Leading Indicator (Divergence).
The Momentum indicator can also be used as a leading divergence indicator much the same way as RSI and MACD can be used as leading divergence indicators.
This method assumes that market tops are typically identified by a rapid price increase (when everyone expects prices to go higher) and that market bottoms typically end with rapid price declines (when everyone wants to get out). As a market peaks, the Momentum indicator will climb sharply and then fall off, diverging from the continued upward or sideways movement of the price. Similarly, at a market bottom, Momentum will drop sharply and then begin to climb well ahead of prices. Both of these situations result in divergences between the indicator and prices.
Here is a simple table to define the different divergences:
|Name||Indicator / Price||Location|
|1. Bullish Divergence Reversal||Mom is making a higher low /
Price is making a lower low
|2. Bearish Divergence Reversal||Mom is making a lower high/
Price is making a higher high
|3. Bullish Divergence
|Mom is making a lower low /
Price is making a higher low
|4. Bearish Divergence
|Mom is making a higher high /
Price is making lower high.
Let us look at such a divergence in a H4 chart of EURUSD:
In the last buy signals in the above chart, Price had been making a Lower Low while the corresponding Mom had been making a High Low, which indicates Bullish Divergence Reversal Signal. With the sell signals, Price had been making Higher High while Mom had been making a Lower High, which indicates a Bearish Divergence Reversal Signal.
Momentum is perhaps the simplest constructed indicator out there. What can be simpler than taking the current close, dividing it by the close of x bars ago, and multiplying by 100. You get to see at a glance the amount and speed by which prices have changed from x bars ago. And the only variable to optimize is x, or MomPeriod.
As we have seen, there are at least three strategies that can be worked out with momentum:
- taking trades when mom crosses 100;
- taking trades when mom crosses down/up through a predetermined overbought/oversold zones; and
- taking trades on mom divergences from price action.
The first strategy is the most popular of the three, so it might be the best one to start testing. But bear in mind, ROC Momentum has been unsteated in popularity by more sophisticated momentum indicators that followed it, such as RSI and stochastics. This older (simpler) version of momentum has some merit, but you have to examine each of the three strategies related to it with a degree of skepticsm: each must be backtested on different pairs across a sufficient period of historical data to determine if indeed they impart any edge factor.
Another indicator that is classified as a momentum oscillator and is simple to understand while being highly useful is called the relative strength index (RSI.) RSI is calculated by taking the average of the closes of the up bars (the up frequency intervals) and dividing them by the average of the closes of the down bars. The RSI measures the ratio of up-moves to down-moves and normalizes the calculation so that the index is expressed in a range of 0-100. Currencies that traveled strongly upwards have a higher RSI than those that have traveled strongly down.The calculation is usually performed over the close of the last 14 periods, of any time frame.
The RSI ranges between 0 and 100, and different levels of that range will register different trading signals:
|RSI Level||Trading Action|
|70-100||Extremely Bullish and Overbought|
|Previously above 70, now below||Short Signal|
|0-30||Extremely Bearish and Oversold|
|Previously below 30, now above||Long Signal|
We will review each of these signals below.
Trading Trends the RSI Crossing 50
The simplest way to use the RSI is the crossing of the 50 line as a signal of trend direction. If RSI crosses above 50, it is considered bullish. If it crosses below, it is considered bearish. This is not the best way to trade the RSI, but it can act as a confirmation of trend, in conjunction with other signals.
If the 50 line seems too simple for you, you may take Andrew Caldwell’s idea of defining the Bull Range as the RSI moving up between 40-80, and the Bear Range as the RSI moving down between 60-20. Charts trade within these zones all the time so it is easy enough for me to present you a simple example of such:
You can see by the red box how the RSI on the USDCHF daily chart was moving from 60 to 20, indicating the downward trend. This trend gets more significance due to the fact that the RSI could not remain long above 70, where the market was severely overbought.
The more popular entry system for RSI is trading trading trend reversals after exhaustion in the overbought/oversold regions of 70/30.
Trading Trend Reversals after Exhaustion in Overbought/Oversold Regions of 70/30
The RSI usually tops above 70 (Overbought Region) and bottoms below 30 (Oversold Region). While it is tempting to try to trade these regions, it is advised to look at them as a pending reversal opportunity. DO NOT take reversal trades within these zones. Reason: it is uncertain how far price will continue its advance/decline, making any counter-trend trade taken within overbought/oversold zones very dangerous. Instead, one should be looking for the opportunity to take a counter-trend trade only when the RSI crosses 70 from above for short signal or crosses 30 from below for long signal. For instance, if the RSI penetrates above the 70 overbought region in a bullish phase and briefly tops at 80, but cannot continue the advance and instead falls back below 70, a short signal is generated.
|Short Signal||Previous RSI > 70
Current RSI < 70
(Crossing under 70 from above)
|Long Signal||Previous RSI < 30
Current RSI > 30
(Crossing over 30 from below)
RSI period of 14 is usually appropriate, but different overbought/oversold zones can be explored, such as 75/25 or 80/20.
Here is a 14 period, 75/25 RSI on an hourly chart of GBPUSD, taken for the summer months of June and July, 2012, with short signals taken when the RSI crosses under 75 and long signals taken when the RSI crosses over 25:
Summer months are typically range bound as the deep money traders are enjoying their vacation, so a RSI counter-trend strategy on these months could be a safe bet. With some exceptions, the signals seem to catch the market just before it reverses direction, at least for a few pips and sometimes for quite a bit more. Knowing when to exit an RSI strategy is a little tricky, and it is advised to back test for a stop loss that is seldom hit and a take profit that is often achieved.
Here is an example from the previous month of May where GBPUSD had been continously falling, travelling in and out of the 25 Oversold Region, which would have triggered a number of buy trades that would have been stopped out:
Trading the cross under/over the 75/25 lines might work well in a ranging or sideways market, but it can wither down your account when the market is strongly trending.
Stochastics are among the most popular technical indicators when it comes to Forex Trading. Popularity is difficult to quantify, but according to a quick review into the free indicator/EA repository of Desynced.net, it is the fourth most popular indicator used as a basis for EA construction:
|Popularity Rank||Indicator||EAs Based Upon||Indicators Based Upon|
|8||Larry Williams Percent Range||62||183|
|9||Movement Directional Index||59||240|
The late George Lane, a professional trader for 50+ years and widely respected technical analysis educator, developed this indicator in the late 1950s in order to measure the current close relative to the range (high/low) over a set of periods.
Stochastic is a momentum oscillator, which consists of two lines:
- %K (or Main Line) = this is the main Stochastics line and it displayed as a solid line
- %D (or signal Line) = this is simply a moving average of the %K, it is sometimes called the signal line, and is displayed as a dotted line.
The trigger levels are added to the chart at 20 and 80. When the Stochastic lines are above 80, the market is considered overbought, and when below 20, oversold.
Traders have adopted stochastics to measure trend direction, trend strength, and trend change. Here are the levels and their importance:
|Stochastics Level||Trading Action|
|between 30-50 and rising||Bullish|
|80-100||Extremely Bullish and Overbought|
|Previously above 80, now below||Short Signal|
|between 70-50 and falling||Bearish|
|0-20||Extremely Bearish and Oversold|
|Previously below 30, now above||Long Signal|
We are most concerned about the two signal methods:
- Method #1: Stochastic Line Crossing Signal Line
- Method #2: Stochastics Crossing Overbought/Oversold Zones
Each method is simple to learn and use.
Method 1: Stochastic Crossover of Signal Line
Basically, this is the crossover of the faster moving main Stochastic line (%K) over or under the slower moving Signal Line (%D). This crossover looks similar to moving average crossover, wherein the trade signal is derived from the fast line crossing the slow line.
|Buy Signal||Stochastics Line (%K) crosses above Signal Line (%D)|
|Short Signal||Stochastics Line (%K) crosses under Signal Line (%D)|
Could be fixed stop loss determined by backtesting, or simply an exit via the opposite trade signal:
|ExitBuy||When Stochastics Line (%K) crosses above Signal Line (%D).|
|ExitSell||When Stochastics Line (%K) crosses below Signal Line (%D).|
Example of Bullish Crossover on EURUSD Daily Chart:
From February to May 2011, the EURUSD was in a strong bullish uptrend, and if one would have played the crossover method, it would have been smart to only trade the long side of the crossover (indicated by the blue arrows), and exiting and staying out of the market at the short side of the crossover (indicated by the red boxes). There would have been 5-6 fantastic buy signals to position one into the market at a fair market price, just after the market had been in a brief bearish phase. Once you know the overall trend of the market, you can play the side of the trend to great effect using stochastic crossover method.
Example of Bearish Crossover Method on USD/CHF Daily Chart:
From February to May 2011, the USD/CHF was in a strong bearish downtrend, and if one would have played the crossover method, it would have been smart to only trade the short side of the crossover (indicated by the blue arrows), and exiting and staying out of the market at the long side of the crossover (indicated by the red boxes). There would have been 5 decent sell signals to take advantage of different downward moves on overall downtrend market, and the buy signals (taken only as exits) would have had you exit each of these short trades with nice profit, at the same time helping you avoid some bullish corrective phases that would have ate into your profits.
As we can see from the above illustrations, adding two filters to stochastics signal crossovers enhances performance:
- Overbought/Oversold Filter: Crossovers that happen above 80% level for short trades, and below 20% level for long trades are treated as stronger signals compared to crossovers outside these levels. However, using this filter greatly reduces the number of trades.
- Trending Market Filter: when the market is trending, then signals with higher probability of success are those in the direction of the trend. When the market is trending up, one should only look for oversold conditions to enter a buy trade, and when the market is trending down, one should only look for overbought condition to enter a sell trade. If the market is ranging, or trend-less, you may buy and sell as indicated above, without having to trade in the direction of the trend.
Stochastics Parameters and Time frames:
There are a number of different parameters and time frames that will work for any pair. Some traders have made effective use of a more larger parameter set (21,9,9), while others have shown more promise with the smaller parameter set that is the initial default in MT4 (5,3,3). Some prefer to trade with the daily chart and others with the H1 chart. The choice involves a balance between sensitivity and reliability. Generally, the smaller the stochastic parameters or time frame, the faster it will react to market changes, and the more crossovers will be shown. The downside is that these crossovers can be less reliable. In contrast, the larger the stochastic parameters or larger the time frame, the slower is the reaction time, with the downside being less trading opportunities and upside being more reliable trading signals. Every trader should backtest their stochastic system using different parameters values and different time frames to see which sets and times perform the best.
Method 2: Trading the Overbought / Oversold Zones
Stochastics at 80% level is considered overbought and at 20% level considered oversold. While it is tempting to buy in the oversold and sell in the overbought zones, it must be remembered that these zones can also represent a strong continuation of the current trend. Thus traders should only enter counter-trend trades when Stochastics leaves these zones.
|Buy Signal||Stochastics crosses over oversold level (20) from below.|
|Short Signal||Stochastics crosses under overbought level (80) from above|
Could be fixed stop loss and take profit determined by backtesting, or simply an exit via the opposite trade signal:
|ExitBuy||Stochastics crosses under overbought level (80) from above|
|ExitSell||Stochastics crosses over oversold level (20) from below|
The bane of this counter-trend strategy is that the market continues to trend, and thus there are a couple filters that need to be implemented:
- Trending Market Filter: Do not buy or sell when stochastics falls below or above the zones but only when they emerge from the zones. You are to wait for the stochastic lines to enter into the overbought/oversold zones and then come out of it. When price is trending, Stochastic lines may easily remain in the overbought/oversold zone for a long period of time. To take trades only when the lines are within the zones would be dangerous.
- Trending or non-Trending: If the market is trending, it is a good idea to only trade in the direction of the trend. To take counter-trend trades against the main trend would be dangerous to your account. If the market is ranging, then it can be profitable to take counter-trend trades on both sides of the market. However, determining the timing of when a market begins and ends a trending period, and when it begins and ends a range period, can be difficult. Some currency pairs, such as EUR/CHF and EUR/GBP, exhibit more range-bound behavior than others, and thus they may be more suitable for exploiting both sides of the overbought and oversold zone.
Example of Stochastics Overbought/Oversold Trading on EURCHF Daily Chart:
Since the EUR/CHF is generally a range-bound pair, it is a good one to illustrate how one could have bought and sold whenever Stochastics entered and left the overbought/oversold zones. Between Jan to May on the EUR/CHF daily chart, there have been three times wherein stochastics had entered into the oversold zone of 20 and then left it, resulting in buy signals. It was the first buy signal (brief touch of 20) in January that would have won hundreds of pips, and Stochastics traders could have easily missed this if they were first expecting the line to fall under 20. The short plays were more frequent and powerful. There were five nice short signals initiated when the stochastics entered the overbought zone and left it, and one could have made hundreds of pips on each of them.
Example of Stochastics Overbought/Oversold Trading on GBP/USD Daily Chart:
Between February to May 2011, the GBP/USD had been stuck in a 400 range between 1.6000 and 1.6400, and trading both sides of this range, taking buy trades in the oversold region and sell trades in the overbought region, would have resulted in a nice accumulation of pips. Notice that there was a breakout of the range towards the end of April, when price headed up to test 1.6700. In many markets such a breakout would put a lot of pressure on the preceding short signal that had entered in the overbought zone. However, in this case, the preceding short signal (the fourth red box on the chart) would have entered near the top of the range, at 1.6400, with the market soon after making a low of 1.6169 (250 pips below) before it rocketed back up and through the top of the range. One could have won with this trade if the strategy had a profit target of 200-250 pips, or at the very least exited at a breakeven level prior to the market reversing and breaking through the range. It is with proper backtesting that one can determine the best take profit and breakeven levels for a given currency pair, just in case the market does break the range you are intending to exploit with the overbought/oversold method of Stochastics.