The momentum measures the rate of change in closing prices for a currency pair, a stock or commodity. It is often used to detect weakness or inherent strength in a pair and also signals where potential reversal points are, or when trends are about to begin. Understanding momentum will make it easy for us to really understand the fluctuation in the currency exchange market.
The basic way to use momentum is that when you have high momentum readings either severely to the upside or to the downside that usually occurs when a trend is the strongest. At that point, not only have the big-money players come into a particular move, but also the speculators no longer need to be convinced that this is a real trend and they also start entering the market just to get involved.
How to read Momentum
We often find lower readings of momentum at the start or beginning of a trend. This is mainly because the trend hasn’t built up a massive momentum to one side or the other to really dictate a particular trend or strength. This is key to understanding how to correctly read momentum in the Forex market. When we are in a strong trend either bullish or bearish, momentum precedes price which makes momentum a leading indicator.
Generally, you only want to take a signal from the momentum indicator when it is in line with the dominant trend and if the momentum is going in the opposite direction of the trend it’s recommended to not make a trade. There are several indicators used to measure momentum like the Moving Average Convergence Divergence (MACD), Relative Strength Index (RSI), Stochastic and many more.
The Relative Strength Index
For the purpose of this article, we’re going to use the RSI indicator as our tool to measure momentum. The RSI indicator is one of the most commonly used oscillators among professional FX traders because it tends to be more accurate. The RSI indicator oscillates between 0 and 100 extreme, however, it rarely reaches those levels and usually, it tends to stay within the 20-80 range. The general consensus is that when we have a momentum reading above the 80, traders perceive this as being an overbought condition and vice versa when we have a momentum reading below the 20 traders perceive this as being an oversold condition.
The overbought and oversold strategy is not that reliable because the market can stay within those conditions for a longer period of time before to fully reversing. Because the momentum precedes price we can treat the momentum readings the same way as the price action. When we see breaks in the trendlines for the momentum indicator, they often occur before the breaks in the price action.
Think like a ball thrown up in the air, when you throw up a ball in the air it has upward momentum, but when that ball stops the momentum is already turned downward because the acceleration has stopped. This is the same with the price action in the Forex market. For a pair to fall it means that the momentum has already been falling ahead of the price.
Taking a look at the above example we had a strong trendline on the momentum indicator and also some strong upward movement in the price action, and when that TL on the RSI indicator was broken, it was a warning sign that the trend is coming to an end, and we started very serious reversal. Because momentum always goes ahead of price, when we have a break in momentum, it is a warning sign that the market is losing steam and the prevailing trend is about to reverse.
In summary, the momentum RSI indicator is a very simple indicator in design and to understand. It’s a leading indicator because it is one of the few leading indicators out there which are as unique and powerful. Because you can treat it like price action, it’s very easy to translate the information from the momentum indicator to the price action. The RSI oscillator is good for determining reversal points and thus when to enter or exit a trade.