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.
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.
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.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.
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.
What is the logic behind this idea? The basic premise is that momentum as signified by the MACD histogram can provide clues to the underlying direction of the market. Using the assumption that momentum precedes price, the thesis of the set-up is simply this: a new swing high in momentum should lead to a new swing high in price, and vice versa. Let's think about why this makes sense. A new momentum swing low or high is usually created when price makes a sudden and violent move in one direction. What precipitates such price action? A belief by either bulls or bears that price at present levels represents inordinate value, and therefore strong profit opportunity. Typically, these are the early buyers or sellers, and they wouldn't be acting so quickly if they didn't believe that price was going to make a substantive move in that direction. Generally, it pays to follow their lead, because this group often represents the "smart money crowd".
However, although this set-up may indeed offer a high probability of success, it is by no means a guaranteed money-making opportunity. Not only will the set-up sometimes fail outright by producing false signals, but it can also generate a losing trade even if the signal is accurate. Remember that while momentum indicates a strong presence of trend, it provides no measure of its ultimate potential. In other words, we may be relatively certain of the direction of the move, but not of its amplitude. As with most trading set-ups, the successful use of the momentum model is much more a matter of art than science.
Looking at Entry Strategies
A trader can employ several different entry strategies with the momentum model. The simplest is to take a market long or market short when the model flashes a buy or a sell signal. This may work, but it often forces the trader to enter at the most inopportune time, as the signal is typically produced at the absolute top or bottom of the price burst. Prices may continue further in the direction of the trade, but it's far more likely that they will retrace and that the trader will have a better entry opportunity if he or she simply waits. Figure 3 demonstrates one such entry strategy.
Sometimes price will retrace against the direction signal to a far greater degree than expected and yet the momentum signal will remain valid. In that case, some skilled traders will add to their positions - a practice that some traders have jokingly termed "SHADDing" (for "short add") or "LADDing" (for "long add"). For the novice trader, this can be a very dangerous maneuver - there is a possibility that you could end up adding to a bad trade and, therefore, compounding your losses, which could be disastrous. Experienced traders, however, know how to successfully "fight the tape" if they perceive that price offers a meaningful divergence from momentum.
Placing Stops and Limits
The final matter to consider is where to place stops or limits in such a set-up. Again, there are no absolute answers, and each trader should experiment on a demo account to determine his or her own risk and reward criteria. (To learn more, see Demo Before You Dive In.) This writer sets his stops at the opposite 1 standard deviation Bollinger Band® setting away from his entry, as he feels that if price has retreated against his position by such a large amount, the set-up is quite likely to fail. As for profit targets, some traders like to book gain very quickly, although more patient traders could reap far larger rewards if the trade develops a strong directional move.
Traders often say that the best trade may be the one you don't take. One of the greatest strengths of the momentum model is that it does not engage in low probability set-ups. Traders can fall prey to the impulse to try to catch every single turn or move of the currency pair. The momentum model effectively inhibits such destructive behavior by keeping the trader away from the market when the countervailing momentum is too strong.
As Kenny Rogers once sang in "The Gambler", "You've got to know when to hold them, and you got to know when to fold them". In trading, as in poker, this is the true skill of the game. The simple momentum model we've described here is one tool that we hope will help currency traders improve their trade selection process and make smarter choices.