The currency momentum factor is an important feature that is commonly observed and monitored in foreign exchange, as well as in the currency market, cryptocurrency, and financial trading. Investors, stock brokers, and even realtors keep an eye on this because they know that a trend in the currency momentum factor is more crucial than a change in price.
Moreover, the momentum strategy is always a robust anomaly that needs in-depth research. It follows the trend to make positive returns at a rate that changes from time to time. Also, the trend changes, thus the upward and downward trend over a period of time.
Take a look at the momentum trading in this article to understand the currency momentum factor better.
Momentum Trading, What Is It, and How Does it Work?
Momentum trading is a strategy used by investors to maximize profit while the market is in a profitable trend. The goal is to get the best out of market volatility, but it requires thorough risk management in playing the market to avoid the low profit. Momentum profits are believed to spring from one common factor in a variety of asset classes.
Richard Driehaus, an American investor, used the momentum trading strategy in his fund management. He applied the strategy wherein buying high to sell at a higher price is more profitable. This strategy eventually became the basis for momentum investing.
It works by buying while in short-term uptrends or peak momentum, and when securities begin to crash or lose their momentum, selling them is the right move. The investor looks for another opportunity for a short-term uptrend and then repeats the cycle.
Currency Momentum Factor
In momentum trading, the currency market also has its momentum factor that foreign exchange investors and traders can maximize and capitalize on for profit. As observed by the experts, currency exchange rates move the trend upward or downward multiple times in a year. Because of the multi-year trends, positive returns are significantly generated over time.
Spot rates show market supply and demand in real time. For currency pairs, constant returns in the current spot rates are the primary driving force behind the currency market, not the interest rate. Unlike the traditional carry trade strategy, wherein currencies are borrowed at a low-interest rate and lent for a high-interest profit, the momentum strategy focuses more on going for short or long currencies.
Forex traders execute momentum strategies freely because past losses will not block the short-selling of assets. Foreign exchange can still be profitable because it is more liquid compared to other assets that have high transaction volumes whether the previous ones were positive or negative.
Moreover, the currency momentum returns are far different from carry trade returns and generated returns in trading. Currency momentum, on the other hand, is affected by the irrationality of traders or investors as they overreact or underreact to the currency momentum factor.
2 Forms of Currency Momentum Strategy
There are two forms of currency momentum strategies:
Time-series Momentum
It is also called a trend-following strategy, taking advantage of the upward trend. The returns are larger when the market is at extreme events.
Cross-sectional Momentum
It is a strategy that considers the ranking of stocks based on their performance and trend, giving importance to the previous rank to predict relative wins in the future.
In comparison, the time-series momentum strategy focuses more on absolute performances and that it is superior to the other strategy because it does not look at the winner-loser portfolio. Meanwhile, the cross-section strategy focuses more on relative performance and considers rank markets.
In the 1970s, there were only ten currencies in the market that are convertible and liquid. Today, there are more than thirty currencies included in foreign exchange trading. This is the result of the time-series and cross-section momentum strategies. Also, only bankers and foreign exchange traders handled the trading before. These days, various brokers, traders, and asset managers play a key role in the currency markets.
Momentum-based Currency Portfolio, What’s the Benefit?
A research paper written by Grobys, Heinonen, and Kolari stated that using a momentum-based currency portfolio brings the investment to an edge. As they discussed, they explained that this strategy can be used to hedge the stock portfolio, seeing that the upward trend is sustained.
Currency Momentum Factor Supported by Empirical Evidence
Momentum trading is not only observed and researched but also documented, especially in the foreign exchange markets. In fact, Polichronis, Drew, and Bianchi discussed it in their paper entitled “A Test of Momentum Trading Strategies in Foreign Exchange Markets: Evidence from the G7.” The goal of this paper was to answer the questions: 1. Do foreign exchange markets have momentum? 2. How does transaction cost impact the excess returns, and 3. Can excess returns come through a consolidated trading signal? They used the results of G7 from 1980 to 2004 as empirical evidence to find the answers to these questions.
In 2003, Okunev and White analyzed and observed eight foreign currencies in 20 years on their use of the time-series strategy. Burnside, Eichenbaum, and Rebelo made also their analysis in 2011 of the equally-Weighted momentum portfolio and the return in currencies.
In 2021, Shaojun Zhang made a study of the forty-eight market currencies that emerged from 1976 to 2020. She dissected different currency returns to further analyze and compare the relation of currency momentum factor With the other strategies. She concluded that factor momentum alphas become significant and larger but momentum returns are not able to span factor momentum. Despite the unconditional correlation, momentum returns are closely related to factor returns.
Meanwhile, Cass Business School in London also did thorough and in-depth studies of the currency momentum factor, together With the use of time-series and cross-section momentum strategies. One thing they found out is that high yields come With high risks to returns.
Tools to Measure Momentum
To determine and measure the currency momentum, here are the tools used by the experts:
Average Directional Index
The average directional index or ADX is a tool used to measure the strength of the currency trend. However, this tool cannot measure the direction. It can only screen trends and define their strength, as well as enhance the trading strategy by simply removing trades that are on the way to losing.
Moving Averages
Moving averages or MA is a tool used to measure momentum by taking the average of the price for a particular period to see the direction of the trend. It is also used by investors and traders to determine the strongest momentum.
Moving Average Convergence Divergence
Moving Average Convergence Divergence or MACD refers to the tools used to measure the oscillating momentum by comparing two moving averages and their differences. The calculation is based on the difference between the longer moving average and the shorter moving average. It identifies market momentum to determine which one is favorable.
Rate of Change
Rate of Change or ROC is a tool used to measure the change in rate or percentage of the price of the asset. It compares rates between the previous period and the most recent period. This tool also indicates the change in trend, chart divergence, conditions sold and bought, and the confirmed trend.
Relative Strength Index
Relative Strength Index or RSI is a tool used to measure the movement of a rate whether it is an upward or downward trend. The value of RSI is between 0-100, wherein high value depicts overbuying and low value over selling. In the RSI measurement, the ups and downs of a trend over a period of time are compared.
Stochastic Momentum Index
The stochastic momentum index or SMI is a tool used to measure and compare the closing price of the asset for a period of time. In measuring the price, most traders use this tool to determine the levels of assets that are overbought and oversold and how they reverse the momentum. In stochastic measurement, a range of 80 depicts overbuying and a range of 20 and below depicts overselling.
Conclusion
The currency momentum factor is a topic that requires thorough explanation and discussion, especially when it comes to the forex markets. Although the strategies are high yielding with a 10% per year excess rate of return, it is evident that there are risks in terms of high credit. Returns, however, are not only based on traditional risk factors or systematic risk but also on high credit risks.
Moreover, currency momentum shares several flaws as well. There are observations and pieces of evidence that show that momentum portfolios work in the foreign exchange markets but they are skewed primarily to currencies with high transaction costs. In such a relation, minor currencies contribute more than 50% of the returns. Because of this rate, the concentration is more focused on minor currencies, thus imposing higher risks that cannot be detected.
Time is also a factor in momentum profits because it poses threats to short-term trading in the foreign exchange markets. On the other hand, the currency momentum factor can be greatly improved to be profitable by targeting or scaling specific volatility. The strategy may not guarantee profits and a high rate of returns to all investors and traders but it is safe to say that using it works. `
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