One of the key tenets of technical analysis is that price frequently lies, but momentum generally speaks the truth. Just as professional poker players play the player and not the cards, professional traders trade momentum rather than price. In forex FXa robust momentum model can be an invaluable tool for trading, but traders often grapple with the question of what 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.
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 forex 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: If house prices in New York were higher in November than in October, then we could safely conclude that demand for housing trading 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 changewhich 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. Using the Forex Histogram To Measure Momentum Rate of change can be measured in a variety of ways in technical analysis; a relative strength index RSIindicator 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. To learn more, see Moving Average Convergence Divergence - Part 2. First invented by Gerry 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. To learn more, see Trading The MACD Divergence and Basics Of Weighted Moving Averages. In addition, a nine-period EMA of MACD itself is plotted alongside the MACD and acts as a trigger line. 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.
This oscillation of the MACD around the nine-period line trading first plotted into a histogram format by Thomas Aspray in 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. 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.
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 forex of a short, the process is simply reversed. Having noted the prior high or low in the preceding segment, you can then use that value to construct the model. Moving on to Figure 2, we can see that the preceding MACD high was.
If the MACD histogram now registers a downward reading whose absolute value exceeds. If the case were reversed and the preceding MACD segment were negative, a positive reading in the present segment that would exceed the forex 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 momentum the market.
Using the assumption that momentum precedes price, the thesis of the set-up is simply this: Let's momentum 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 indicator 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 set-up 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 set-ups, the successful use of the momentum model is much more a matter of art than science. Looking at Entry Strategies A trader can employ several different entry strategies with the momentum model. The simplest is to indicator 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 he or she simply waits. Figure 3 demonstrates one such entry strategy. Sometimes price will retrace against the direction signal to a far greater degree than expected and yet the momentum signal will remain valid.
In that case, some skilled traders will add to their positions - a practice that some traders have jokingly termed "SHADDing" for "short add" or "LADDing" for "long add".
For the novice trader, this can indicator a very dangerous maneuver - there is a possibility that you could end up adding to a bad trade and, therefore, compounding your losses, which momentum be disastrous.
Experienced traders, however, know how to successfully " fight the tape " if they perceive that price offers a meaningful divergence from forex. Placing Stops and Limits The final matter to consider is where to place stops or limits in such a set-up. 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.
To learn more, see Demo Before You Dive In. As for profit targets, momentum traders like to book gain very quickly, although more patient traders could reap far larger trading if the trade develops a strong directional move. Conclusion 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 indicator. Traders can fall prey to the impulse to try to catch every single turn or move of the currency pair.
The momentum model effectively inhibits such destructive behavior by keeping the trader away from the market when the countervailing momentum is too strong. As Kenny Rogers once sang in "The Gambler", "You've got to know when to hold them, and you got to 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 currency traders improve their trade selection process and make smarter choices.
Dictionary Term Of The Day. A legal agreement created by the courts between two parties who did not have a previous Latest Videos PeerStreet Offers New Way to Bet on Housing New to Buying Bitcoin? This Mistake Could Cost You Guides Stock Basics Economics Basics Options Basics Exam Prep Series 7 Exam CFA Level 1 Series 65 Exam. Sophisticated content for financial advisors around investment strategies, industry trends, and advisor education. Keep An Eye On Momentum By Boris Schlossberg Share.
Figure 2 What is the logic behind this idea? Figure 3 Sometimes price will retrace against the direction signal to a far greater degree than expected and yet the momentum signal will remain valid.
Figure 4 As Kenny Rogers once sang in "The Gambler", "You've got to know when to hold them, and you got to know when to fold them". Currency traders can use this method to avoid stop-order triggers before the real reversal. This type of strategy demands controlled decision-making, requiring a continual refinement of entry and exit techniques.
Two indicators are usually better than one. Find out how this pairing can enhance your trading. Learn how this momentum indicator is used to determine price action on a stock.
The MACD is a popular moving average based indicator, and it is signaling the downtrend will continue in these stocks. One of the most popular trading indicators is the MACD, and right now it's flashing a bullish signal in these four stocks. Learn the importance of the moving average convergence divergence, or MACD, and understand why traders consider it an important Explore two frequently used momentum indicators in forex trading, the moving average convergence divergence, or MACD, and Consider some forex trading strategies that can be designed using the exponential moving average EMA lines on the moving Learn some common trading strategies that traders employ using the moving average convergence divergence MACD technical Take a look inside one of the most popular and widely trusted technical indicators, the moving average convergence trading, Discover common divergence strategies that utilize either stochastics or the MACD, the two most frequently used momentum A legal agreement created by the courts between two parties who did not have a previous obligation to each other.
A macroeconomic theory to explain the cause-and-effect relationship between rising wages and rising prices, or inflation. A statistical technique used to measure and quantify the level of financial risk within a firm or investment portfolio over Net Margin is the ratio of net profits to revenues for a company or business segment - typically expressed as a percentage A measure of the fair value of accounts that can change over time, such as assets and liabilities.
Mark to market aims A simple, or arithmetic, moving average that is calculated by momentum the closing price of the security for a number of time No thanks, I prefer not making money. Content Library Articles Terms Videos Guides Slideshows FAQs Calculators Chart Advisor Stock Analysis Stock Simulator FXtrader Exam Prep Quizzer Net Worth Calculator.