Momentum is a theory in physics, and at its base is an equation, multiplying mass by velocity. The product of this equation shows us what the possibility of an object continuing its movement in the same path is. How does momentum help us in trading?
The momentum in forex trading relates to the acceleration of the price of the asset (for example, a currency or a stock). It is a strategy that traders follow, which is based on price direction. As the price moves in a certain direction, it will continue doing so until it loses its momentum. Thus, momentum in trading is a strategic tool in determining and predicting the price direction, whether upwards or downwards.
However, there are multiple factors that must be taken into consideration, such as trading volume and price change.
Let’s clarify it in a practical and simple way, with an example from daily life. Let’s say you’re at the train station, and the train is ready to go. At first, it takes time for the train to accelerate and reach its desired speed. Later, the train reaches that desired speed. Does it stop? No, but it stops accelerating. The train continues to move at the same speed.
At the end of the train journey, it begins slowing down with the brakes, coming to a complete stop at the station. As a trader, the best part of your investment is during the journey, while the train is at its fastest speed. It may lead to huge profit returns.
How to apply momentum to your trading strategy?
The trend line is one of the most important tools which help traders with momentum strategy. What is a trend line? It is a line drawn from the high to the low price or vice versa in a certain time frame.
By reading the trend line, a momentum trader can determine the direction of the price. If the line is going up, then buying the asset is recommended. If the line is going down, then selling the asset is recommended.
Therefore, it can be said that momentum strategy is a technical indicator of asset prices, now and during a specific period of time.
The equation for momentum in trading: An asset’s current closing price, subtracting the closing price at a certain period of time (CP – nCP).
This equation shows the extent to which the asset’s price has moved, either upward or downward. A positive result to this equation means that the price is rising, and a negative one means that the price is decreasing. Of course, the same applies to the percentage.
Is momentum trading risky?
In the beginning, you can easily apply momentum as part of your trading strategy. You just have to choose the appropriate time spread and apply it to your portfolio.
The more complex part is to determine the period of time in which you want to measure the asset’s movement, and whether the momentum theory applies to that time or not. To keep things simple, you can rely on this strategy in a general manner.
When you see that the market is performing well and on the upside, apply the momentum strategy and ride the wave in order to achieve a predetermined profit, and so on.