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.

Using the MACD Histogram To Measure Momentum
Rate of change can be measured in a variety of ways in technical analysis; a relative strength index (RSI), a commodity channel index (CCI) or a stochastic oscillator can all be used to gauge momentum. However, for the purposes of this story, the MACD histogram is the technical indicator of choice. (To learn more, see Moving Average Convergence Divergence - Part 2.) 

First invented by Gerry Appel in the 1970s, the MACD is one of the simplest, yet most effective, technical indicators around. When used in FX, it simply records the difference between the 26-period exponential moving average (EMA) and the 12-period exponential moving average of a currency pair. (To learn more, see Trading The MACD Divergence and Basics Of Weighted Moving Averages.) In addition, a nine-period EMA of MACD itself is plotted alongside the MACD and acts as a trigger line. When MACD crosses the nine-period line from the bottom, it signifies a change to the upside; when the move happens in the opposite manner, a downside signal is made.

This oscillation of the MACD around the nine-period line was first plotted into a histogram format by Thomas Aspray in 1986 and became known as the MACD histogram. Although the histogram is in fact a derivative of a derivative, it can be deadly accurate as a potential guide to price direction. Here is one way to design a simple momentum model in FX using the MACD histogram.

1.    The first and most important step is to define a MACD segment. For a long position, a MACD segment is simply the full cycle made by the MACD histogram from the initial breach of the 0 line from the underside to the final collapse through the 0 line from the topside. For a short, the rules are simply reversed. Figure 1 shows an example of a MACD segment in the EUR/USD currency pair.

Figure 1

2.    Once the MACD segment is established, you need to measure the value of the highest bar within that segment to record the momentum reference point. In case of a short, the process is simply reversed.

3.    Having noted the prior high (or low) in the preceding segment, you can then use that value to construct the model. Moving on to Figure 2, we can see that the preceding MACD high was .0027. If the MACD histogram now registers a downward reading whose absolute value exceeds .0027, then we will know that downward momentum has exceeded upward momentum, and we'll conclude that the present set-up presents a high probability short.

If the case were reversed and the preceding MACD segment were negative, a positive reading in the present segment that would exceed the lowest low of the prior segment would then signal a high probability long.

Figure 2