Momentum trading is an investment strategy that involves buying an asset that has shown a significant movement in price or volume. Momentum trading can be explained by the buy high, sell the higher plan.
The investor buys a stock or an asset while its price shows significant upward movement or a positive trend. The investor aims to initiate transactions that benefit from the positive direction.
It is a probabilistic trading strategy that attempts to profit from predictability in the short-term price movements of a financial asset. Momentum trading strategies aim to take advantage of the exaggerated price move toward the prevailing trend, determined using multiple periods. This can be applied using technical analysis and is often compared to trends in more traditional investment markets such as currencies, bonds, and commodities.
Table Of Content
- What is Momentum Trading?
- How Does Momentum Trading Work?
- Special Indicators to Identify Momentum
- Momentum Trading Strategies
What is Momentum Trading?
Momentum is a technical trading theory that describes supply and demand in financial markets, particularly in price fluctuations, that suggests that asset prices that have been rising steadily are likely to continue growing for some time, or vice versa for asset prices falling. This can be explained but the tendency of assets prices to rise or fall from their current values.
The framework of a momentum system is similar to that of a trend-trading system. Momentum traders use indicators to measure price movements and calculate trends. Some indicators measure the strength of the market, in which case traders would buy into markets that are rising and sell into markets that are falling.
Other momentum indicators measure the momentum change, determining when to trade and what direction to go. The goal for every trader using a momentum indicator is to spot the turning points before other investors do. When price trades above a moving average, buy above an uptrend line, or prices break through resistance levels, this information tells traders that buying is the right way to play the trend, and they should increase their positions.
When price trades below a moving average, sells below an uptrend line, or prices break through support levels, this information tells traders that selling is the right way to play the trend, and they should decrease their positions. When these signals start appearing, traders open new orders or modify existing ones to benefit from the anticipated profits.
How does Momentum Trading work?
As per Momentum Trading, you should enter a stock when its price has just started moving up and exit as soon as it starts declining. The idea behind this strategy is that the costs of stores often don't reflect their actual value for an extended period, and they tend to move in one direction for long periods.
Momentum trading is a strategy that aims to capitalize on the continuance of existing trends in the market. Momentum traders usually buy or sell an asset moving intensely in one direction and exiting when this movement shows signs of reversing. They also seek to avoid buying or selling assets that are moving sideways.
Momentum trading requires identifying the prevailing trend and then picking stocks that have the most robust momentum within that trend.
For example, suppose you are bullish on the Indian stock market and would like to go long on stocks with solid momentum. You would first look at a chart of the Nasdaq And S&P 500 index to identify the prevailing trend (upward) and then identify stocks with solid upward momentum within this broader bullish trend.
Momentum traders do not hold stocks for long periods; they enter and exit trades quickly, sometimes having stores for as short a day or even an hour or less, depending on their technical indicators.
Momentum Trading Strategies
Momentum traders and investors look to take advantage of upward trends or downward trends in a stock or ETF's price. We've all heard the old adage, "the trend is your friend." And who doesn't like riding a trend? Momentum style traders believe that these trends will continue to head in the same direction because of the momentum that is already behind them.
- Consider the risks of momentum trading
It's important to understand that momentum trading involves a good deal of risk. In essence, you're making a decision to invest in a stock or ETF based on recent buying by other market participants. There's no guarantee that buying pressures will continue to push the price higher. For example, a news development may impact investor market perception and lead to widespread selling. Or, with many investors already holding a long position in the ETF or stock, it's possible that profit-taking on existing positions will overpower new buyers coming into the market, forcing prices down.
- Follow these steps to find the best sectors
To be a successful momentum trader, you need to be able to identify the best sectors quickly and accurately. You can probably do this manually with many screeners out there, but the basic steps are as follows:
- First you need to identify the stocks and ETFs you are interested in.
- Determine the number of stocks and ETFs trading close to their yearly highs.
- Sort the chosen stocks and ETFs from highest to lowest to see which are doing the best.
- Devise an entry strategy. You may want to enter when an instrument is showing short-term strength or wait for a pullback and buy on weakness. Either approach can work; the important point is to execute a plan.
- Devise an exit strategy. You should know going into the trade at what point (or conditions) you will take profits and at what point (or conditions) you will exit with a loss.
- Ways to find price trends
One method to find the top stocks and ETFs is to look at the percentage of stocks and ETFs trading within 10% of their 52-week highs. Or you may like looking at the percentage price change over just the last 12 weeks or 24 weeks. Generally, the former method is more sensitive to recent price movements.
Take the oil and energy sector in mid-2008 as an example. Based on its 12-week or 24-week price performance, it was continuously ranked as one of the top sectors using those metrics even while it was collapsing. That was because the gains were so large in the first part of the 12- or 24-week periods, even a large pullback over a span of many weeks got lost within the larger run-up that preceded it.
To spot trends early on, you may want to include a shorter-term price change component, for example a 1-week or 4-week price change measure. This works both getting into and getting out of a particular stock or ETF.
- Look at the highs
If you're looking at a price momentum, you're going to be looking at stocks and ETFs that have been continuously going up, day after day, week after week, and maybe even several months in a row. Some people hate getting into markets making new highs. But it's important to know that there's a lot of evidence that shows markets making new highs have a tendency of making even higher highs.
- Pay attention to volatility
Momentum trading carries with it a higher degree of volatility than most other strategies. Momentum trading attempts to capitalize on market volatility. If buys and sells are not timed correctly, they may result in significant losses. Most momentum traders use stop loss or some other risk management technique to minimize losses in a losing trade.
Popular momentum indicators
Momentum traders aren’t necessarily worried about the fundamentals of the underlying asset such as its long-term growth prospects and the economic circumstances surrounding it. All a momentum trader generally cares about is price action. This is why most momentum traders rely heavily on technical analysis and indicators to determine when to enter and exit each trade.
Popular momentum indicators include
- The momentum indicator
- The relative strength index (RSI)
- Moving averages
- The stochastic oscillator
Momentum indicators
The momentum indicator is, as you might expect, the most popular momentum indicator. It takes the most recent closing price and compares it to the previous closing price, which can be used to identify the strength of a trend.
The indicator is an oscillator; it is displayed as a single line which moves to and from a centreline of zero (or 100 on some charts). The value of the indicator line provides traders with an idea of how quickly the price is moving. For example, if the indicator gives a reading of 35, this would be a faster uptrend than a reading of 30. If the indicator gave a reading of -15, this would be a faster downtrend than a reading of -10.
Although some traders will use the indicator to enter and exit traders, most momentum traders will use it to confirm a price action. For example, if the indicator line crosses the zero line from below, it is a sign that the price is starting to gain momentum higher, while a drop below the zero line shows the price is gaining downward momentum.
Relative strength index (RSI)
The relative strength index (RSI) is a momentum-based indicator which provides buy and sell signals. Like the momentum indicator, it is plotted on a separate chart and is an oscillator moving from zero to 100.
It is similar to other range-bound indicators, in that it provides overbought and oversold signals depending on its value. Anything above 70 is considered overbought, and anything below 30 is considered oversold.
This momentum strategy is based on the idea that retracements between these price levels will present clear trends. Momentum traders would open and close positions within a trend, rather than at the top and bottom.
When using the RSI, it is important to note that just because the indicator gives overbought and oversold signals, doesn’t mean the trend is going to reverse. As you can see from the above price chart, the signal line remained in the overbought territory for a sustained period of time. This makes it important to use the RSI alongside other indicators.
Moving averages
Moving averages (MAs) are used by traders to spot emerging trends in markets. They use a formula that filters out random fluctuations to show a prevailing price trend. Although MAs are not a momentum-based indicator, they can help momentum traders see whether a market is rangebound or not.
For example, on the above chart there are three moving averages applied: a 15-day, 25-day and 35-day. For the most part of the price action, the moving averages (MAs) are on top of each other, with the shortest-term MA on top and the longest one on the bottom. This tells us that the market is trending, and that the trend is accellerating.
When using moving averages, it is important to be aware that they are a type of lagging indicator this means that the signals happen after the price move. Although a momentum trader wouldn’t necessarily enter at the start of a trend anyway, this does mean they will need to use other indicators to find a suitable exit point. As you can see from the above chart, the MAs cross over indicating a trend reversal after the price has already declined slightly.
Stochastic oscillator
The stochastic oscillator compares the most recent closing price to the previous trading range, over a specified period of time. This indicator does not follow price or volume, but rather the speed and momentum of the underlying market.
The stochastic is considered a leading indicator, so it can be used to predict price movements. It is formed of two lines on a price chart:
The indicator line: this is a rangebound line that oscillates between zero and 100 if there is a reading of over 80 the market is considered overbought, and if there is a reading below 20 it is considered oversold
The signal line: this is drawn onto the same price chart. If the signal line and indicator line cross, it shows that a change in direction is likely to happen
If the stochastic fails to fall back to the 20 mark during a pullback, then it can be taken as a sign that the trend will continue upward. For example, looking at the price chart above, we can see that on the whole the two lines have remained above the oversold signal, and the trend has continued upward. This is an indicator that despite pullbacks, the overall momentum is up.
Momentum trading is based on volume, volatility and time frames
Momentum trading works by enabling traders to identify the rate of change in an asset’s price or volume. As neither price or volume will continue in one direction indefinitely, momentum is usually thought of as an oscillating measure
Momentum traders focus on price action rather than long-term growth and fundamentals
Popular indicators for momentum trading include the momentum indicator, the RSI, MAs and the stochastic oscillator