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. Importantly, it signals where potential reversal points are or when trends are about to begin.
Forex traders will always be looking for momentum, and changes in it. It makes it easy for us to better predict the fluctuations in the currency exchange market.
A trend is the strongest when there are high momentum readings to the upside or to the downside. At that point we know two things to be true.
- We know the big-money players join in on a particular move.
- We know that the speculators no longer need convincing that this is a real trend and they have entered the market.
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. 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. These are the Moving Average Convergence Divergence (MACD), the Relative Strength Index (RSI), Stochastic and 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 used oscillators among professional FX traders as it tends to be more accurate. The RSI indicator oscillates between 0 and 100. It rarely reaches the extreme levels and usually stays in the 20-80 range.
The general consensus is that when we have a momentum reading above 80, traders perceive this as being an overbought condition. In the opposite situation, when we have a momentum reading below 20 traders perceive, this as being an oversold condition.
The overbought and oversold strategy is not that reliable because the market can stay like this for a long time before reversing. Because the momentum precedes price, we can treat the momentum readings the same way as price action. When we see breaks in the trendlines for the momentum indicator, they often occur before the breaks in the price action.
Think of momentum like a ball thrown up in the air. When you throw up a ball in the air, it has upward momentum. But when the ball stops, the momentum is already turned downward because the acceleration has stopped.
This same is 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.
Take 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. 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 a very serious reversal.
Because momentum always precedes price, whenever 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 to understand. It’s a leading indicator because it is one of the few leading indicators out there which are as unique in this simplicity and very powerful. Because you can treat it like price action, it’s very easy to translate the information from the momentum indicator into the price action. The RSI oscillator is good for determining reversal points and thus when to enter or exit a trade.