Forex Momentum Trading Strategy: Ultimate Guide 

To succeed in highly volatile markets like Forex, it’s crucial to have a well-suited trading strategy. Among the plethora of options available, momentum trading strategies are increasingly popular. Forex Momentum Trading Strategy entails trading financial assets based on recent price movements, cashing in on upward or downward trends until the trend dies down. Simply, a trader aims to gain an advantage by leveraging market momentum. Let’s ride the waves and hopefully come out on top! 

The nature of how people trade in the financial markets has certainly evolved over time. With today’s advanced computer programs, it’s possible to quickly identify and trade assets whose prices are increasing or decreasing. As more and more people start to see the value of a certain asset increase or decrease, they start to buy or sell as well, creating a “momentum” effect in the market as a whole. Due to ‘herd mentality’ and ‘fear of missing out’, most retail traders can’t help but follow suit. 

What is a Momentum Trading Strategy? 

A momentum trading strategy is a type of trading style where traders purchase or sell financial assets based on the strength of recent price trends. This approach involves leveraging market momentum by identifying assets that are exhibiting signs of strength to the upside or downside. The underlying theory is that if enough momentum exists to push a price in a certain direction, the trend is likely to persist for a while. 

Trading momentum can be done in two ways: 

1. Short-term momentum: Capturing short-term price trends is the objective of this strategy. Depending on the situation, it could be minutes, hours, or even days. The momentum trading strategy can be used in any market environment and with any chart time frame. The day trader is a short-term momentum trader, who closes all of their trades at the end of the day. 

2. Longer-term momentum: Traders who utilize longer-term momentum identify uptrends and downtrends in the market and individual assets using daily, weekly, and monthly charts. Using more extended time frames eliminates much of the noise and volatility that comes with shorter time frames. 

Momentum trading strategies are based on analyzing the movements of prices, rather than looking at fundamental factors, such as economic growth. This method of trading is quite popular among traders who operate over shorter time periods. However, here traders create projections of momentum prices based on past price trends and data.

What influences ‘Momentum’ in the Financial Markets? 

Since financial markets are very volatile, prices may change suddenly and move in unpredictable directions. Additionally, the markets are influenced by news releases and macroeconomic events, which must be factored into a momentum trading strategy and an associated risk management plan. ‘Momentum’ in the financial markets can be influenced in several ways: 

1. Volume:

In trading, volume is the total amount of an asset traded within a timeframe, not to be confused with the number of transactions. Volume is critical for momentum traders who rely on continuous buyer and seller flows to enter and exit positions quickly. A high volume indicates a liquid market, making it easier to exchange assets for cash, while a low volume signals an illiquid market. For example, if five buyers purchase one asset each, the volume is the same as if one buyer bought five of the same assets. 

2. Volatility:

Volatility is vital for momentum traders, as it reflects price fluctuations. They prefer highly volatile markets to benefit from short-term changes in an asset’s value. However, it’s important to have an efficient risk management plan to mitigate potential losses due to market volatility. Stops and limits are commonly used to protect trades. Appropriate risk management measures help traders maximize profits in volatile markets. 

3. Time frame:

The chosen timeframe can have a significant impact on momentum trading. Momentum trading strategies generally concentrate on capturing short-term market movements, but the length of a trade may depend on how long the trend sustains its momentum. As a result, momentum trading can be appropriate for traders who prefer both longer-term styles, such as position trading, and shorter-term styles, such as day trading or scalping.

How does ‘Momentum’ work in Forex Trading? 

For trading in highly volatile spheres, such as the foreign exchange (FX) market, a momentum trading strategy can prove to be an extremely valuable tool. 

Similar to how professional poker players focus on their opponents’ tendencies rather than the cards, many professional forex traders rely on the momentum of the market rather than the price of the currency pair. 

Here are some reasons why momentum trading is relevant to forex trading: 

1. Capitalizes on market volatility: Volatility is a common feature of forex markets, and prices can change rapidly in response to economic news or events. Momentum traders use this volatility to their advantage, identifying trends that are likely to continue in the same direction. 

2. Takes advantage of liquidity: Forex markets are the most liquid markets in the world, with billions of dollars traded each day. This makes it easier for momentum traders to enter and exit trades quickly and with low transaction costs. 

3. Adapts to changing market conditions: Momentum traders are constantly monitoring the market for changes in trends and adapting their strategies accordingly. This can be particularly useful in volatile markets where conditions can change quickly. 

4. Offers potential for high returns: By focusing on strong trends, momentum traders can potentially earn higher returns in a shorter period of time than other trading strategies. 

The objective of a momentum trader is not to predict the exact starting and ending points of a trend, but rather to exploit opportunities arising from the central movement of the trend. Thus, such traders may adopt a strategy of buying high and selling even higher.

Riding the Forex Market Waves! 

In momentum-based forex trading, the approach is to purchase currencies that have shown high excess returns in the recent past (known as “winners”) while selling currencies with low excess returns (known as “losers”). The objective is to establish a long position in a portfolio of winning currencies and a short position in a portfolio of losing currencies.  

A winning forex portfolio may include high-interest-rate currencies such as the New Zealand dollar, as well as low-interest-rate currencies such as the Japanese yen or Swiss franc, based on their short-term performance. 

A key characteristic of the momentum strategy is that the long-short combination requires more frequent rebalancing than the Carry Trade strategy, resulting in a less stable currency composition over time. This can result in potentially significant transaction costs. 

What are Momentum Trading Patterns? 

Technical analysts use momentum trading patterns to analyze price movements. A chart pattern can reveal market trends and predict future price movements of an asset, as well as help a trader determine whether a current trend is likely to weaken. Chart patterns can be used for all markets, but stock and forex markets are particularly useful. Take a look at our guide to chart patterns here.

Momentum Trading vs Trend following 

Trend following is a trading approach that involves the identification of trendlines in price charts for trading assets. Like momentum strategies, trend following also emphasizes price action, with a focus on buying high on uptrends and selling low on downtrends. However, there are some key differences between the two approaches. 

Momentum-based trading typically incorporates aspects of fundamental analysis in making trading decisions, while trend followers concentrate solely on price and the size of their trades. This helps to reduce time and facilitate faster trades while minimizing losses. In trend following, the position size is determined in accordance with the trend rather than placing a large amount of capital in a single position.

Momentum Trading vs Swing Trading 

Momentum trading and swing trading are both popular approaches in the world of trading, but they differ in some important ways. 

Momentum trading is a strategy that involves buying assets with recent strong price movement, with the expectation that the trend will continue. Momentum traders buy high and sell even higher, seeking to profit from the momentum of the market. The holding period for momentum trades is generally short, ranging from a few minutes to a few days. 

Swing trading, on the other hand, is a strategy that involves holding an asset for a longer period of time than momentum trading, typically ranging from several days to several weeks. Swing traders tend to buy and sell at support and resistance levels and trade within ranges. They also use technical analysis to identify potential trading opportunities and often employ a range of trading tools such as moving averages, trendlines, and chart patterns.

Intraday Forex Trading with Momentum Strategy 

One key advantage of intraday forex trading with the momentum strategy is that it allows traders to take advantage of short-term market movements while minimizing exposure to longer-term market risks. 

In this approach, traders use technical analysis to identify currencies that have been showing strong positive or negative movements in recent timeframes. The objective is to capture gains by buying high and selling higher (or vice versa), and the holding period is generally short, lasting from a few minutes to a few hours. 

To implement the momentum strategy, traders use various technical indicators such as moving averages, MACD, RSI, and Bollinger Bands to identify potential trading opportunities. They may also use chart patterns, support and resistance levels, and other technical analysis tools to confirm their trades.

Popular Momentum Indicators Used in Forex Trading 

Momentum traders focus primarily on price action and do not typically concern themselves with the underlying asset’s long-term growth prospects or the economic conditions surrounding it. Rather than analyzing fundamentals, momentum traders heavily rely on technical analysis and indicators to determine the appropriate times to enter and exit trades. 

Popular momentum indicators used in forex markets include: 

1. Momentum Indicator 

2. Relative Strength Index (RSI) 

3. Moving Averages 

4. Stochastic Oscillator 

5. Bollinger Bands 

Momentum Indicator 

The momentum indicator is the most commonly used indicator for measuring momentum. It compares the most recent closing price to the previous closing price to determine the strength of a trend. As an oscillator, it is displayed as a single line that moves back and forth around a centerline of zero (or 100 on some charts). Traders can use the value of the indicator line to gauge the speed at which the price is changing. For instance, a reading of 35 suggests a faster uptrend than a reading of 30, while a reading of -15 indicates a faster downtrend than a reading of -10. 

Although some traders utilize the momentum indicator to enter and exit trades, most momentum traders use it to validate price action. When the indicator line crosses the zero line from below, it signals that the price is starting to gain upward momentum, whereas a drop below the zero line indicates that the price is gaining downward momentum. 

Relative Strength Index (RSI) 

The RSI is an indicator based on momentum, which offers signals for buying and selling. It functions as an oscillator and is plotted on a separate chart, with a range from zero to 100. Similar to other indicators that are range-bound, it provides indications of overbought and oversold conditions based on its value. If the value is above 70, it is considered overbought, and if it is below 30, it is considered oversold.  

The momentum strategy assumes that retracements between these price levels will show distinct trends. Momentum traders will open and close positions during a trend instead of at the top or bottom. However, it’s important to keep in mind that the RSI giving overbought and oversold signals doesn’t guarantee the trend will reverse. 

Moving Averages (MAs)

Traders utilize moving averages (MAs) to identify emerging market trends by employing a formula that filters out erratic fluctuations to exhibit the prevailing price trend. MAs are not momentum-based indicators, but they can help momentum traders recognize whether a market is stuck in a range or not. In the provided chart, three MAs with different term lengths – 15-day, 25-day, and 35-day – are applied. 

The MAs overlap for the majority of the price action, with the shortest MA at the top and the longest at the bottom. This informs us that the market is in a trend and that the trend is gaining momentum. It is essential to remember that MAs are a type of lagging indicator, implying that the signals occur after the price movement. Although a momentum trader would not necessarily enter the market at the onset of a trend, they would need to utilize other indicators to determine a suitable exit point.  

Stochastic Oscillator 

The stochastic oscillator compares the most recent closing price to the previous trading range within a specific timeframe.  

As a leading indicator, stochastic can forecast price movements. It is comprised of two lines on a price chart: 

• The indicator line: a rangebound line that oscillates between zero and 100 – if the reading is over 80, the market is regarded as overbought, and if it is below 20, it is deemed oversold. 
• The signal line: is drawn onto the same price chart. If the signal line and indicator line intersect, it implies that a change in direction is probable. If the stochastic fails to revert to the 20 mark during a pullback, it can be seen as an indication that the trend will persist upward. 

This indicator does not track price or volume, but rather the speed and momentum of the underlying market. 

Bollinger Bands 

Bollinger Bands indicator is frequently utilized in momentum trading strategy to identify changes in momentum and to ascertain whether the market is overbought or oversold.  

This indicator consists of three bands that are plotted on a price chart: 

• The middle band: a moving average that represents the mean price over a specified period. 
• The upper band: set at a standard deviation above the middle band. 
• The lower band: set at a standard deviation below the middle band. 

When a price moves toward the upper band, it is an indication that the market is overbought and may be primed for a reversal. On the other hand, when a price moves toward the lower band, it is an indication that the market is oversold and may be poised for a price increase. 

Average Directional Index (ADX) 

The ADX indicator is used to determine whether or not a trend is gaining momentum or losing momentum, and how strong it is. It is calculated by taking a moving average of price action over a period of time, and as a result, is shown on the graph as a single line. 

When the ADX value is 25 or higher, there is a strong trend in the market, whereas a value below 25 is considered weak, and momentum traders will usually avoid using strategies within this range if they are experiencing a weak trend. In terms of a chart, higher peaks show that the trend momentum is rising, while lower peaks show that the trend momentum is entering a downtrend, which is when a trader should exit their position at this point in time.

Forex Momentum Trading Strategy -The Process 

Momentum Trading simply means ‘buying’ something if it is going up, and ‘selling’ it if it is going down. Multiple academic surveys have demonstrated that utilizing this principle across various speculative markets can result in long-term profitability and a competitive trading advantage. Nevertheless, it is crucial to apply this principle correctly to your trading strategy, and the following is a systematic guide to do so. 

Step #1: Selecting Currency Pairs 

A successful momentum trading strategy depends on choosing the right currency pairs. If you want to be able to make informed decisions about the trend, you should stick with the major currency pairs. Since the currencies listed in major forex pairs account for the majority of transactions involving goods, services, income, and financial assets and liabilities, identifying trend changes and their longevity is usually relatively straightforward. 

Step #2: Identify the Trend 

You can recognize an uptrend by observing a series of higher highs followed by higher lows. For an uptrend to be defined, there must be two HH and at least two HL. Basically, a higher high is a swing high that is higher than the previous swing high. In contrast, a higher low simply refers to a lower swing low than the previous swing low. 

There is no doubt that the trend is the friend of momentum traders. However, without momentum behind a trend, there may be no trend at all. In order to gauge momentum, active traders also pay attention to actual price action. Furthermore, momentum indicators should be considered as well. 

Step #3: Look for Confirmation Signs 

Simply looking at the length of a candlestick can be a helpful way to read momentum in a price chart. It is important to see big, bold bullish candlesticks that close near the higher end of the candlestick in an uptrend. 

It is also important to use multiple confirmation signs when buying and selling to enhance the likelihood of a successful trade. Accordingly, a successful momentum trading strategy employs not only the best Forex momentum indicator but also price action. 

Step #4: Wait for Oversold Conditions (Below -80) 

Buying should only occur after the indicator has become oversold (below -80), then has rallied above the -50 level. The best forex momentum indicator, Williams %R, will be used smartly here. Once the indicator reaches oversold conditions (below -80) and rallies above the -50 level in an uptrend, buy. 

With the price and indicator both confirming the move, we have two pieces of evidence. There is real momentum behind this trend, and there is a high probability that prices will rise further in the future. 

It is important to note that if the best forex momentum indicator continuously stays in overbought territory (above -20 level), it indicates a strong trend or momentum. In reverse, the same applies to downtrends. 

Step #5: Place the Stop Loss 

There is a gap below the most recent higher low level that formed after the algorithm generated the buy signal. If you prefer, you can also trail your stop loss below each most recent higher low. By using this strategy, you will be able to lock in profits in case of a sudden market reversal. 

As part of the best momentum trading strategy, we must also take profits from the momentum indicator strategy, which leads us to the last step. 

Step #6: Take Profit at Previous Higher Low 

Trends can remain in motion for much longer than anyone anticipates. Our strategy of letting the market tip its hands before liquidating our trades allows us to maximize our potential profits. A break in the trend structure is important in this regard. In other words, a break below the highest low of the recent past. Alternatively, you can take a profit after the indicator breaks below -50. 

Want to test your Trading Strategy before it goes live? 

The effectiveness of demo accounts in trading platforms cannot be overstated. Using a Demo account is a great way for traders to familiarize themselves with the trading platforms before they open real money accounts. It is highly recommended that beginners practice on demo accounts before entering live trades. This helps newbies understand the market and the risks involved. Brokers that offer demo accounts with virtual trading balances and unlimited access are the best places to trade. 

AximTrade provides a comprehensive set of educational resources, technical analyses, and educational materials, making it one of the best platforms for beginners stepping into the world of Forex trading.

Forex Momentum Trading Strategy: FAQ