The Momentum is often used by forex traders as a proxy for measuring the market volume. When the momentum is high (e.g. prices are changing rapidly), it’s likely that a large number of traders are buying or selling, as they are trying to push the price change in either direction. When this indicator is very high, it means that a currency pair is overbought. When it is very low it means that it is oversold.
More in details, when the momentum hits an extreme low and then rapidly bounces back upward across the zero line, this can be read as a buy signal, while when it hits an extreme high and then rapidly falls below the zero line, this can be read as a sell signal.
The calculation of the momentum of a price is straightforward. Let us define M as the momentum, or the difference between the current closing price (P) and a closing price observed “n” periods ago (Pn). Then, the momentum is caputered by the following formula: M = P – Pn. This indicator does not provide much information beyond what a trader can observe just by looking at a simple price chart. If the price is moving higher, the bounce will be observable on the price chart. This is why the Momentum indicator is used by forex traders not to obtain trade signals, but rather to get confirmation about the validity of transactions executed based on price action (breakouts or pullbacks).