How to Use a Momentum Indicator in Forex Trading

The momentum indicator is pretty self-explanatory by definition. It is a tool to determine the momentum that a financial instrument has when it is falling or rising in the exchange rate. However, when we ask the question “how to use the momentum indicator” usually the answer is to only activate it when the market is growing.
 
Very rarely do we see the momentum indicator used for declining markets, as people don’t really try to generate payouts off of their preferred currency pairs when they lose ground. However, when it comes to stocks, most investors would use the momentum indicator to see how much potential the fall has to continue into the future.
 
Furthermore, it’s believed that markets tend to rise much more often than fall, hence the more active use during bullish sentiments rather than bearish.
In this momentum indicator tutorial, you will learn how to calculate the momentum of the market, how the formula works, and what you can use the information you gain from this indicator for.
 
We will go into quite a lot of detail in order to make sure that everything about the indicator is covered, including the installation process as well as the use cases of the tool.

Momentum indicator calculation - how to do it

Imagine that the USD/JPY currency just jumped significantly because of some kind of market news or a random spike during peak hours of trading. Most people would see this as a perfect opportunity to enter the market, but the issue here would be that there is no reasonable belief on whether the uptrend will continue or fall flat within a couple of hours or days.
 
This is where the momentum indicator shines in all of its usefulness. The lines displayed on the chart would signal the traders whether or not the momentum of a specific asset’s growth is positive or negative. If the momentum indicator Forex shows that the market sentiment is positive, it is very likely for the currency pair to continue rising in price for at least the same trading session.

However, much like everything else in Forex trading, there is always something that cannot be predicted that could hinder the progression of momentum. This is what people call a momentum fluke, as the market suddenly changes its direction with the indicator not having enough time to react.
 
In order to avoid being a “victim” of this abrupt stop, most people conduct momentum calculations on their own. The calculation is quite simple compared to other tools as it comes with a momentum indicator formula, which is the following: “Z = X - Xy”
 

• Z is the momentum
• X is the latest price of an instrument
• Xy is the price of an instrument y days ago

 
The most common numbers you will find with this indicator are 4, 7 and 21, which are usually representations of trading days. 4 represents the current trading session, 7 represents the trading sessions including weekend stagnations and 21 represents the monthly progress.

Mistakes to avoid when using the momentum indicator

One thing that needs to be considered when using this tool is that it’s not magical and doesn’t guarantee a 100% success rate. It’s something that needs to be taken into account with other tools as well. Here we will list a few mistakes that a momentum indicator strategy should avoid for it to be a bit more effective.

Mistake 1 - using the momentum indicator alone

As already mentioned above, a momentum indicator is a background tool. It does not give very specific signals on where it is best to enter the market. For example, imagine that the indicator is showing that there is very high momentum with the USD/JPY tool, it does not, however, show which price point is good to enter in order to avoid as much risk as possible. That role falls onto the Pivot Points that could be a very useful tool alongside the momentum indicator.

Mistake 2 - blindly trusting the momentum meter Forex indicator

Another mistake that has been observed among beginner traders is that they trust the momentum indicator too much. Although it is a very good and useful tool, its use should always be moderate. For example, imagine that the price of a currency pair has just jumped significantly and the momentum indicators are showing positive results. However, you decide to check the news or look at your volume indicator to make sure that this is something that’s sustainable.
 
Soon you find out that the growth was based on news that market changes will be happening for 1 day and the volume is significantly lower than the momentum itself. Even the best momentum indicator would not show these metrics, therefore blindly trusting only one tool may not be the best of ideas.

Mistake 3 - using the indicator on a declining market

Although the momentum indicator has its uses during a declining market as it can show the momentum of the fall as well, it’s definitely not as effective as using it on a rising market. There are not too many traders that go short on a high-momentum price drop simply because it always has an abrupt stop. And it’s quite common knowledge that FX markets tend to correct themselves after a fall quite quickly. Therefore there’s always the risk of having an abrupt stop to the momentum and a quick rebound of the market on a shorting position. All in all, the momentum indicator MT4 would not be as useful on a declining market as it would be on a rising one.