Momentum trading is a hot topic in the financial markets. It is one of those trading strategies that can help a trader define ideal entry and exit positions. That information can potentially generate high profits, though often at a high cost. Still, many Wall Street elites swear by momentum investing. It has an array of powerful indicators that can help you navigate the financial markets like a pro.
Momentum trading is a strategy that looks at how strong recent price movements of an asset are to determine the best time to buy or sell. If there is enough strength behind the price action, then it will likely continue in that direction for some time. That’s the basic idea.
In physics, the term momentum simply refers to the quantity of motion an object has. The greater the force, the longer it will stay in motion. It will keep going until it encounters an equally strong force to counter it. Momentum investing works on a similar principle.
Let’s say the price of an asset starts going up. More buyers will want to enter the market, which causes the price to go even higher. This momentum will likely go on until sellers start to enter the market, causing it to stall. Eventually, once the sellers outnumber the buyers, the asset’s price drops, and the momentum will change direction.
As a momentum trader, your focus is on identifying assets with strong momentum. Then you take a corresponding position to take advantage of the expected price movement. When the momentum starts to sputter out, you close the position and gather your profits.
Momentum trading has been in existence for hundreds of years, as far back as the late 1700s. British classical economist David Ricardo was known to have used a series of trading strategies based on momentum investing to achieve great success in the market.
By 1937, the idea was formalized in academic studies. Since then, it has been used by notable traders, including Jesse Livermore and Richard Dennis.
However, it is the famous fund manager and investor, Richard Driehaus, credited with being the father of momentum trading. He believed that he could make more profit by buying a security at a rising price and selling it at an even higher price, in contrast to buying an underpriced asset and waiting for the market to turn.
Today, we can use momentum investing in several markets. These include the Stock market, Commodities market, Futures market, and even the Forex market.
Key Components of Momentum Investing
There are three main components to consider when it comes to momentum trading.
Volume simply refers to the quantity of a particular security that people trade over a given period. Keep in mind that this is not the same as the number of transactions. Instead, it is how much of the asset was actually bought or sold.
Volume is important to momentum trading because it tells the trader whether that asset has enough demand and supply, as well as whether it is easy or difficult to trade. Momentum traders go for high-volume securities because it means the market is liquid, allowing them to quickly enter or exit the market as needed.
Volatility is a measure of how significant a change occurs within a price movement over a given period. High volatility means the asset has experienced huge, erratic price swings, which a momentum trader will typically favor. That’s because momentum traders can take advantage of short-term price changes.
That being the case, a highly volatile market also means the price can swing the other direction and result in huge losses. As such, it is important to have a solid risk management system in place, such as a stop-loss or stop-limit order.
3. Time frame
Momentum trading strategies generally focus on the short-term. Especially since price movements do not usually maintain their direction for long in a volatile market. However, there are cases where the price action can sustain its trend in a particular path over an extended period.
The actual time frame then depends on the strength and duration of the momentum. This makes momentum trading suitable for both short-term and long-term traders.
Types of momentum
There are two main types of momentum that you should know about, Absolute and Relative. The prevailing difference between them is how they analyze the price action of an asset and its resulting momentum.
Absolute momentum looks at the price performance of the asset compared to past price movements over a given period. It’s basically comparing price momentum against its historical self.
On the other hand, Relative momentum compares the price performance of individual assets against the price movements of different assets within the same class. For example, let’s say the price of silver is going up and you want to buy some. You’d first look at the price action of other precious metals like gold and platinum to get a general idea of the overall asset class momentum.
How Momentum Trading Can Help You
When appropriately executed, momentum trading can help you identify profitable entry and exit positions. Momentum is an excellent way to evaluate price action, since rising prices typically attract even more buyers, thereby pushing up the price further. Once you’ve confirmed the momentum, you can take an entry position and make a profit as long as the trend continues.
On the flip side, when the price falls, sellers flock to the market, pushing the price even lower. Once you’ve confirmed the trend with a momentum indicator, you can then exit your position and avoid incurring losses on the expected price drop.
Momentum investing has become increasingly popular, especially with advancements in financial technology. There are now smart trading algorithms that can quickly identify the strength of an asset’s price movement. This allows them to take an upward or downward position accordingly in a matter of seconds. As more buyers or sellers jump in, the momentum intensifies.
Selecting the right assets for Momentum Trading
Choosing the right asset to trade is as important as the trading strategy you employ, if not more important.
With momentum trading, ideally, you want to go for liquid securities so you have enough room to quickly enter and exit as needed. As much as possible, it’s best to avoid leveraged instruments and inverse ETFs since their price swings are not as straightforward nor as accurate, compared to other simpler traded securities.
Look at the volume of trades over the last couple of sessions. You’ll want to go for securities that trade at least a few million shares per day and then compare them to the current trading volume. It’s a good way to confirm if more traders are entering or exiting the market enough to create momentum, following recent price action.
Keep an eye on current events as well. Favorable or unfavorable news that somehow involves a relevant industry or company can impact the market momentum of a security, giving it a boost or abruptly interrupting it.
Momentum trading is mostly concerned with monitoring price action. So naturally, traders have to rely on technical analysis indicators to confirm the momentum before taking a position.
Momentum indicators help you gain insight into how rapidly an asset’s price moves in a given direction and whether it is likely to continue on the same trajectory. Some tools also help you identify potential trend reversals.
With that in mind, let’s look at some technical indicator tools commonly used in momentum trading strategies:
1. Moving Averages (MAs)
Moving averages are used to identify the prevailing price trend of a traded asset over a given period. It plots the price movements of a security in relation to its average price over a particular time frame. This can also help the momentum trader spot potential emerging trends.
MAs are a type of lagging indicator, meaning the signal will not show on the chart until AFTER the price move has occurred.
This momentum indicator evaluates the closing price of a security compared to its price over a given period. Stochastics are used to identify whether the asset is overbought or oversold through a bounded range of values from 0 to 100.
If the asset is deemed overbought and due for a correction soon, then the trader sells. The reverse is the case if oversold.
3. On Balance Volume (OBV)
On Balance Volume measures buying and selling pressure in an attempt to predict price changes. The chart represents this as a line tracking the daily volume over a given period. If the current volume closes above the volume of the previous day, we consider it positive. If it closes below, it’s we consider it negative.
OBV is essential in momentum trading because it provides reliable feedback when trying to confirm the underlying trend. This allows the trader to identify potential price changes.
4. Stochastic Momentum Index (SMI)
Like other oscillators, the stochastic momentum index measures the strength of a price movement to confirm a potential momentum. The main difference is that SMI uses a broader range of values and is more sensitive to the closing prices.
Rising closing prices above the median of the low/high price ranges signify that the market is bullish. Conversely, dropping closing prices below the median of the low/high price ranges indicate a market downtrend. This is what makes the SMI particularly useful in momentum investing.
5. Moving Average Convergence Divergence (MACD)
The MACD comprises of two moving averages (fast and slow exponential moving averages) compared against a signal line. The exponential moving average (EMA) lines converge, diverge, and overlap with each other on the chart, indicating changes in momentum.
In this way, the momentum trader can confirm market trends, as well as spot potential reversals.
6. Average Directional Index (ADX)
Traders use this tool to determine the direction and strength of a price trend. On the chart, the ADX can show whether to enter or exit the market, or whether you should even consider taking the trade. This helps you make informed trading decisions, mainly when used in conjunction with other momentum indicators.
7. Commodity Channel Index (CCI)
Another oscillator on the list, the CCI, can also tell you when the stock price approaches overbought or oversold conditions. It compares the current price of the security to its average price over a given period.
Momentum traders can use CCI to compare price action over multiple periods in order to identify dominant market trends and make informed buy or sell decisions.
8. Relative Strength Index (RSI)
RSI measures the strength of recent price action and the speed at which they change to determine ideal entry and exit positions. As an oscillator tool, it also shows whether the security is currently overbought or oversold and is measured on a 0 to 100 scale.
If the indicator is below 30, then it indicates the stock is oversold and will likely bounce back. This attracts buyers to the market, which in turn can fuel the momentum. If it’s above 70, then it is deemed overbought and will likely be sold off over the next couple of trading sessions or days.
Momentum Trading Strategies
At its core, momentum investing is about predicting the price action of a security so you can quickly cut losses and let profitable stocks continue to run. As such, the trading strategies often revolve around buying securities that are on the rise and riding out the trend until it stalls.
As more and more traders take up buy positions, the momentum gets stronger, pushing the price higher. With that in mind, let’s look at some common momentum trading strategies:
Look for highs
When considering price momentum, look for securities with steady, consecutive closing highs over time. This will give you an idea of which securities have sufficient momentum to start trading.
As a momentum trader, it is important to first confirm that the market is not just closing at new highs, but that it will continue to do so even after you’ve bought the security so you can later sell at a profit.
Check resistance levels
Securities that are testing their resistance levels are ideal for momentum trading since they can intensify buying or selling pressure if they break through the resistance. However, it is not enough that the asset breaks its resistance.
This is where your knowledge of technical momentum indicators will be most useful. For instance, you can use the stochastic indicator to see if the security is overbought or oversold. Then use OBV to measure volume once it breaks resistance to identify potential momentum behind the movement.
Have a watchlist
Momentum traders typically have a watchlist of securities that they monitor outside of the chart information. Political upheavals, pandemics, and global unrest can significantly sway market direction, so it’s essential to stay in the loop with current affairs.
Don’t follow the herd
Generally speaking, being a successful trader means identifying the top and bottom of a market trend to enter or exit at the most lucrative points. However, this doesn’t necessarily hold true for momentum trading. Instead, your focus is on being in the main body of the price action and letting the ‘herd mentality’ and ‘fear of missing out’ of other market participants push your position towards profitability.
Advantages & Disadvantages of Momentum Trading
Has the potential for high profit over a short period. If the security you’re trading is backed by strong momentum, then you’re looking at potentially steady gains for the duration of the trend.
Benefit from market volatility. Many traders stay away from volatile securities because of the risks involved. But that just leaves room for momentum traders to step in and try to make some profit.
Benefit from the emotional decisions of other traders. Herd mentality can push the buying or selling pressure of an asset. Therefore, all you have to do is pick your security and wait for the traders with enough emotional motivation to push the price towards profitability. Then wait and ride out the trend.
It can be highly time-intensive. Being a successful momentum trader requires you to spend a lot of time monitoring the market. Sometimes this means studying charts every hour, looking for ideal stocks to trade, and continuously checking for any news updates that may influence investor decisions.
Potential risks. No trading method is without its risks. In momentum trading, the market is extra sensitive to external news, and a rising momentum can turn around just as quickly. That’s why it’s crucial to have a solid exit strategy in place to cut losses quickly and lock in profits.
When is the best time to use momentum trading?
The best time to execute momentum trading strategies is when the price of the security is moving at its fastest and there is enough volume to fuel the trend.
What is the best momentum indicator?
This will typically depend on your trading style and which momentum indicators you can read best. However, sometimes it’s best to use more than one momentum indicator to have a more accurate view of the market.
Which chart patterns are important in momentum trading?
With momentum investing, you’re looking for chart patterns that give you insight into the strength behind a trend to spot potential reversals. These include double tops and bottoms, rounding bottoms, rising and falling wedges, and cup and handle.