How to Measure Momentum in the FOREX Market
Momentum is a measure of the stability of previous returns from an investment. Many trading strategies assume either momentum continuation or momentum reversal. In the FOREX market, each currency pair has its own momentum. Technical analysts use several different quantitative tests, or oscillators, to gauge the momentum of a currency pair. Traders search for indications of momentum reversal: an "overbought" condition precedes price downturns, whereas an "oversold" momentum reading is a buying opportunity.
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Instructions
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Relative Strength Indicator (RSI)
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1
Calculate the exponential moving average (EMA) for the previous 14 days in which a currency pair -- the price ratio of the two currencies you are trading -- has closed at a higher price than the previous day's close. An EMA is a moving average in which the newest prices carry more weight than the oldest prices. Most FOREX analysis software programs are capable of generating user-specified EMAs, but you can hand-calculate it using this formula:
Current EMA = previous EMA * (1 - weight) + (weight * current price)
and building up the answer from two days until 14 days. The weight can be any number between zero and one. A higher weight discounts older prices faster.
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2
Calculate the EMA for downside prices. It is the same exact formula as that used for the upside prices, except that the chosen 14 days are ones in which the closing price is lower than the previous day's closing price. As with the previous formula, the latest prices will carry more weight than older ones.
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3
Calculate the relative strength indicator (RSI) by dividing the upside EMA by the sum of the upside and downside EMAs and multiplying the quotient by 100. If the reading is 70 or above, the currency pair is considered overbought. An oversold reading is 30 or below. An extreme RSI reading -- close to either 0 or 100 -- signals that a momentum reversal is imminent.
Stochastic Indicator
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4
Calculate the "%K line." It is equal to 100 times the difference of today's closing price minus the lowest low price in the last N days, divided by the difference between the highest high price in the last N days less the lowest low price in the last N days. The input N, the number of days, is commonly set to 14.
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5
Calculate the "%D line." This line is the three-day simple moving average of the %K line. The equation for the %D line is:
(%K0 + %K1 + %K2) / 3
where %K0, %K1 and %K2 are the values of %K today, one day ago and two days ago, respectively.
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6
Evaluate the %D line. A reading below 20 percent indicates an oversold condition; readings above 80 percent are considered overbought. Trades are triggered when a %D line falls below 20 or exceeds 80 and then reverses direction to a value between the two extremes.
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Tips & Warnings
These and other momentum indicators can be combined with trend-following systems. In this mode, buy and sell signals are tempered by the current market trend. A buy signal is only rendered in an up-trending market---indicated by a price series of higher highs and higher lows; the converse is true for a sell signal.
Sometimes, momentum doesn't reverse as expected. A strongly uptrending, overbought currency pair can get even more overbought. Prudent traders always enter stop-loss orders to close unprofitable positions before suffering a large loss.
References
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