The Momentum indicator is often used to spot and trade trends in forex strategies, but how effective has it been in trading major currency pairs in recent years of trading? This article will take a look at one method of trading using the Momentum indicator and how we might choose to apply it to our own strategies.

Momentum Indicator: What is it and how do we use it?

The Momentum Indicator is possibly one of the easiest to calculate and most straightforward indicators in all of technical analysis.

Momentum = Current Closing Price Closing Price N Bars Ago

The sole input for the indicator is the length of look-back periodthe N in the formula above. A longer look-back period creates a smoother line and gives the best sense of overall momentum for the currency pair. Yet a long look-back also operates on a clear delay and is less apt to catch fast shifts in price momentum. Most charting packages use 12 as the default look-back period for the Momentum indicator, and it seems to provide a reasonable compromise between timeliness and accuracy of trading signals.

Momentum Indicator on EURUSD Daily Chart

There are a wide variety of ways that traders use the Momentum indicator, but the vast majority of uses revolve around trading trends in some shape or another. In developing a trading strategy around this technique, we will likely want to develop trade entries that trade in the direction of the trend. Thus we propose the following trading rules to test the effectiveness of the momentum indicator in picking out worthwhile trend trading opportunities.

Given that we would like to trade in the direction of the trend, we will combine the concepts behind the momentum indicator with a straightforward stop-entry system of trading into fresh highs and fresh lows.

Forex Momentum Indicator Strategy

Entry Rule: When the 12-Period and 1-Period Momentum Indicator are above zeroconfirming that overall momentum and very recent momentum point higherplace a stop entry order to buy at the previous bars high plus one pip. When both the 12-Period and 1-Period Momentum Indicator are below zero, place an order to sell at the previous bars low minus one pip.

Stop Loss: None by default

Take Profit. None by default

Exit Rule: Strategy will exit a trade when opposite signal is triggered.

Backtesting our Forex Bollinger Band Reversal Strategy

Using FXCMs Strategy Trader software, we will code a strategy based on this popular technical indicator and see the results. In doing so, we can easily test our concepts across the spectrum of currencies and time frames.

View a video guide on strategy backtesting and optimization in Strategy Trader here:

Download and install the Strategy Trader platform. then import the following code example from the DailyFX forex forum. Download the attached .zip file. Go to the directory under which you’ve unzipped the contents of the file. Open the Momentum.fxd file and when prompted by the Strategy Language Editor, hit OK to import the file. Once you have imported the Strategy Advisor, open the Momentum_DailyFX.fxw file included in the attached zip to see examples on how you may use this in your charts.

Forex Momentum Indicator Trading Strategy

We ran this strategy on the EURUSD, USDJPY, GBPUSD, and GBPJPY across four different time frames. We assume transaction costs of 3 pips on the EURUSD, USDJPY, and GBPUSD and 5 pips on the GBPJPY per round-trip trade. Below are the hypothetical equity curves of said strategy run across four different time frames.

Hypothetical Performance of Momentum Strategy from 2001-2010 EURUSD, GBPUSD, USDJPY, GBPJPY charts

Though backtested results are far from stellar, we see some interesting takeaways from using this very simple trading strategies across these four timeframes.

According to our hypothetical trading results, this strategy works best on the lowest-frequency tested Weekly chart. Though there is consistent risk that using technical indicators on weekly charts will introduce too much delay into subsequent trading signals, this particular strategy does especially well in the period from 2006 to present on a weekly timeframe.

Our default input for the Momentum indicator dictates that it looks at the 12-period and 1-period rate of change. On a weekly chart, 12 weeks translates roughly to a quarter of a yearenhancing its significance in determining trends. Confirming the 12-week Momentum Indicator with a 1-period rate of change seems to have historically given relatively good trading signals.

Not to be outdone, the tests run on Daily charts hold promise and show a particularly strong run through most of 2008. Though we cannot honestly claim that a 12-period Momentum indicator holds any real significance (other than being roughly two calendar weeks of trading), the combination of 12-period and 1-period indicators has worked historically well in producing trading signals. This was especially the case through the fast-moving markets of 2008, which saw this example strategy hypothetically perform quite well.

As we move to higher-frequency time frames, we see that our sample trading system does reasonably well on 240-minute charts. Yet much as we saw when we moved from a Weekly to a Daily timeframe, performance becomes significantly more streak-prone. If we take out the period of significant outperformance from late 2008 to mid-2009, the strategy actually loses money over the 8-year testing period. That is hardly a confidence-inspiring backtest and warns that this strategy is very vulnerable to shifts in market conditions.

And finally, the 60-minute chart shows the worst performance through our sample period. This is not to say that the Momentum indicator is less useful in predicting price moves on this relatively high-frequency chart. Yet the simple fact that the strategy will take more trades exposes it to significantly higher transaction costs. In fact, the equity curve on a 15-minute chart (not pictured) is virtually a 45-degree slope downward. It serves to note that much of this strategys losses occurred from 2002-2006 and the equity curve has since been relatively positive. Yet we cannot responsibly claim that these results show any promise as a real trading strategy.

Applying Our Analysis to Existing Strategies/Trading Styles

Our backtests show interesting results with our sample Momentum indicator strategy. The strategy in particular shows promise on lower-frequency charts, while higher-frequency backtests show vulnerability to transaction costs and have been considerably more streak-prone.

We can all the same see that using a standard 12-period Momentum indicator in conjunction with 1-period rate of change has historically produced some accurate trading signals. Though past performance is never a guarantee of future results, our backtests suggest that this is an indicator that holds some promise in everyday trading.

If you would like to suggest ideas for this topic or any other forex strategy you would like to see in this series, feel free to e-mail author David Rodrguez at drodriguez@dailyfx.com. To be added to this authors distribution list, e-mail with subject line distribution list

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