Momentum Trading Strategies

11/09/2015 9:00 am EST

Focus: FOREX

Oftentimes a trader new to the realm of forex can feel overwhelmed in the market, which is why Adam Lemon, of DailyForex.com, outlines a forex 'best of' momentum trading strategy that chooses currency pairs in a way that Adam has found to statistically produce positive returns.

Many forex traders, especially new forex traders, can feel lost and confused in the market. They feel they can make money but they find it hard to achieve this with any kind of consistency. Some end up saying that the market is random or that they are suffering at the hands of cheating forex brokers, but these are usually just excuses. The market certainly is not random and even if your forex broker is less than perfect, you can still make money if you stop and think about the market and apply a top-down approach to your trading. I will show here a method that can be used that chooses currency pairs in a way that statistically produces positive returns.

What Are Forex Momentum Trading Strategies?

Momentum simply means buy something if it is going up and sell it if it is going down. There have been several academic surveys showing that applying this principle to all kinds of speculative markets is profitable over time and gives a winning trading edge.

Another type of forex momentum strategy is a best of momentum trading strategy which buys those assets that are going up the most strongly and sells those going down most strongly. This also tends to work well, and in fact, tends to produce a greater reward-to-risk ratio than simple momentum strategies.

I am going to outline a forex best of momentum strategy that I have developed below, with back test results.

A Forex Best of Momentum Trading Strategy: Selecting Pairs

The first part of the strategy is to create an excel spreadsheet that shows the changes in price over the last three months of a universe of 28 forex pairs and crosses. It is simplest to make this calculation each weekend using weekly open and close prices, as a period of 13 weeks approximates nicely to three months.

I use the 28 pairs and crosses that you get from the seven major global currencies. There is no reason why you cannot add currencies, although the more exotic you get, the more expensive they get to trade.

Choose the six currency pairs/crosses that have moved the most strongly over the past 13 weeks. These are the pairs/crosses you will look to trade over the coming week. You will trade in the direction of the movement. For example, if EUR/USD has changed in value by -5%—and that is the largest change of any pair—you will be looking to trade that pair short.

NEXT PAGE: Why Use a Look-back Period of Three Months?

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Over the past 6.75 years, this method has shown a statistical probability of producing a trading edge. Without refining the method or using leverage, this method has produced a total return of 187.10%, which comes to a very impressive annualized return of 17.01%. The average week has produced a positive return of 0.53% and a median week a return of 0.43%. The average annual return was 23.63% and the median annual return was 19.08%. Performance is shown in the graph below.

chart
Click to Enlarge

You might ask, why use a look-back period of three months? It is simply the period that has worked best over the last seven years or so. Before the financial crisis of 2008, using a 6-month period worked better. Using a 6-month period has also been profitable over the last seven years, but much less so than three months. It seems that shorter periods than three months are too fast and periods longer than six months are too slow.

Trading Selected Forex Pairs

It should be possible to make the overall results even better by applying a position trading strategy to the pairs/crosses and directions you have determined for each week.

My favorite method is to use moving average rules. I like to use an hourly chart with a 3-period EMA and a 10-period SMA. When an hourly candle closes, and the 3 EMA crosses the 10-SMA in the direction of the trend, I enter a position, but only if the price is also on the right side of the 40- and 240-period SMAs. This filter can help keep you out of trades when the momentum isn’t really there.

Of course, everyone has their favorite momentum trading strategy and using an indicator such as the RSI (Relative Strength Index) crossing 50 on all time frames with, say, a 10-period setting can also work very well. Any momentum indicator can be used, really. You can also pay attention to support and resistance of course: but close to support if the trend is long, sell close to resistance if the trend is down, after a pullback. You will usually get the best results by waiting for pullbacks to happen.

For stop losses, I like to use the 20-day Average True Range. It takes experience to manage stop losses manually, but after you get a lot of experience you can learn which ones to cut short: these are mostly the trades that go strongly against you right from the very beginning. If the trade goes in your favor by about 1 ATR, you can look to add to the position upon further moving average crosses, breakouts, or whatever you like: using breakouts to add to positions can work very well. When you have about three positions on it is time to consider taking partial profits and/or moving up stop loss levels to lock in profits.

By Adam Lemon, Contributor, DailyForex.com

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