The magic combination for trading is momentum + trend. If we can jump into a trend on growing momentum, and exit that trend as momentum fades … we’re onto a winner – this is how momentum trading catches the big moves, but sits out when the market is dithering, and not worth risking our money on.
I’m going to look at the most basic momentum indicator – the imaginatively named: momentum indicator. And we’ll see how something very simple can enable traders to spot the right moments to get into trends – and where to take profits.
This means that, through momentum trading, you can be in the market at the optimum time, and – crucially – you can sit out of the market when the signals aren’t strong enough. That’s how profits are protected.
As you can see below, trends tend to be messy things, so if you get in at the wrong moment, even if you’re in the right overall direction, you can still lose money.
That’s why traders need to find a method to time their entry into a trend
The momentum indicator is a very simple tool – it’s nothing more than a measure of how far the price has moved over the past X periods (12 is a standard setting).
There are two ways this is shown, either as simply the current closing price minus the closing price 12 candles ago … or as one figure as a percentage of the other.
The first method will have a midline at zero. The second will have the midline at 100.
The charts I’ll use here show it in the simpler form, where it’s just a measure of how far the price has moved. We’re interested in extremes – where the momentum indicator has pulled away from the midline.
The chart below shows an established up-trend. While it’s a good thing to enter an established trend, if we want to maximize profits and minimize risk, we need to enter the trend wisely. That way we can avoid getting caught in pullbacks and extended sideways consolidations.
And this is where momentum trading can help
We’re interested in where the momentum indicator hits extreme levels – those peaks and troughs. I’ve loosely marked these with the yellow bands, but the actual levels will vary depending on the average move of that instrument. You’ll also notice that the extremes are higher to the upside – this is because the market is in an uptrend, so the positive gains will be greater than the pullbacks.
So, if the momentum indicator hits a high, as it does on the 19th, and then starts pulling back (i.e. the indicator is going down, while the price is moving up) – this is a signal that momentum is fading and it’s a good moment to take profits. The price could be about to pullback or enter a consolidation.
To enter into the trend, we’re looking for momentum lows which are rebounding. These show that a pullback could be coming to an end, and upwards momentum will start growing again.
The momentum indicator can be used in the same way for a down trend …
In a downtrend, we’re looking to enter the trend where the momentum indicator has peaked and resumed a downward move. And we’ll take our profits where the downward momentum has hit a low and is moving back towards the midline.
Note how in a down trend, the lows will be more extreme than the highs.
These are pared-back momentum trading signals
The momentum indicator is a very basic tool for measuring momentum – there are more sophisticated ones out there. But what this really highlights is just how simple it can be to combine trend and momentum – and that really is the key to entering the market.
It’s so easy to get bogged down in ever-more-complex indicators, when in fact, what works is finding something that suits you, and getting proficient at using it.
If you’d like to learn more about trading medium-term trends with a simple momentum trigger, then it’s worth checking out my Heikin Ashi mountain method – I love it because it’s so intuitive to read off the charts … and, of course, because it works so well!