In the foreign exchange market, momentum is level of force behind a change in the price of a currency pair. Traders can measure momentum using various technical indicators, such as the Relative Strength Index (RSI) or the Moving Average Convergence Divergence (MACD).
When a currency pair’s price rises strongly, it is said to have positive momentum. Conversely, when the price is falling, it is said to have negative momentum.
Momentum can be used as a leading indicator to predict future price movements. For example, if a currency pair has been rising for several weeks and shows no signs of slowing down, it will likely continue to rise. However, if the momentum starts to slow down, this could be a sign that the price is about to reverse course.
What to consider when trading with market momentum
It would be best to consider the trend when trading with market momentum. Is the overall trend bullish or bearish? If it is in a strong uptrend, you want to look for currencies that are also in an uptrend. In contrast, if the market is in a downtrend, you should look for currencies also in a downtrend.
The strength of the momentum
The second thing to consider is the strength of the momentum. A currency pair could be in an uptrend, but if the momentum is weak, it could signify that the trend is about to reverse. Likewise, a currency pair could be in a downtrend, but if the momentum is strong, it could signify that the trend is about to continue.
Support and resistance
The third thing you need to consider is support and resistance, which are levels where the price has difficulty breaking through. It could reverse course if a currency pair is an uptrend and hits a significant resistance level. Likewise, if a currency pair is downtrend and hits a significant support level, it could rebound.
How to trade with momentum
Identify the overall market trend
You should first identify the overall market trend. You can look at a longer-term chart, such as a daily or weekly chart.
Find currency pairs that are in a similar trend
The second step is to find currency pairs that are in a similar trend. For example, if the overall market is in an uptrend, you want to find currency pairs also in an uptrend.
Wait for momentum to confirm the trend
The third step is to wait for momentum to confirm the trend. As mentioned, momentum can be measured using various technical indicators, such as the RSI or MACD.
Once you have identified a currency pair with solid momentum, you can enter a trade in the direction of the momentum.
For example, let’s say you identify EUR/USD as a currency pair with strong positive momentum. You would then enter a long (buy) position at 1.3500 with a stop loss at 1.3450 and a target of 1.3600.
Risks of trading with momentum
The trend could reverse
The first risk is that the overall market trend could reverse, which would cause your trade to go against you.
The momentum could fade
The second risk is that the momentum could fade, which would also cause your trade to go against you.
You could get stopped out
You could get stopped out if the price hits your stop loss.
You could miss the move
The fourth risk is that you could miss the move if you don’t enter the trade in time.
How to manage risks when trading with momentum
Use a stop loss
The first thing to do is use a stop loss to help limit your losses if the price goes against you.
Take profits at critical levels
The next thing to do is take profits at critical levels, such as support and resistance levels, to help lock in profits if the price starts to reverse.
Use a trailing stop
A trailing stop could help you stay in the trade if the price continues to move in your favour while protecting your profits.
Check this page for more information.