Keep An Eye On Momentum

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 (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. Here we look at how you can design a simple and effective momentum model in FX using the moving average convergence divergence (MACD) histogram.

Why Momentum?
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.