What Is Momentum Trading?
“The trend is your friend”, momentum traders say. When an asset’s price goes up, that’s the right time to enter the market or buy. And you should buy (go long) because the asset has momentum. Mainly, if the asset in question has had a positive price evolution, chances are it will continue rising. But is this true in real-life trading? How much can you rely on momentum trading or the trend, for that matter?
In this momentum trading guide, we reveal some of the tried and tested strategies using the practice of following the trend to derive profits. For example, if a stock reaches a new high after its issuing company releases record earnings, a momentum trader might buy shares in that stock and try to drive the price higher. Alternatively, momentum traders might join in a so-called short squeeze (the artificially induced action of buying a stock/an asset to push the price upward, as was the case with AMC or GameStop), hoping that it would continue to drive the price higher.
Momentum trading in laymen’s terms
The concept of momentum in physics refers to the amount of motion used by a moving body. For example, when a car accelerates, you can very well say it’s “gaining momentum”. Well, the concept is not alien to trading either.
Momentum trading is an investment strategy that aims to capitalise on an asset’s price directional movements. Trends can be determined by actual events, such as earnings reports, analyst or expert opinions, market sentiment, economic drivers, etc., or they can be purely technical. Actually, technical analysis relies on patterns and indicators to spot and analyse trends.
You can use momentum either to go long (buy) or short (sell). All the recent meme stock rallies we’ve witnessed in the past couple of years are forms of short-term momentum trading, as is trading based on earnings releases. However, there are also momentum stocks on a consistent long-term uptrend, as is Tesla. Arguably, Tesla has been a momentum stock for a decade. This type of long-term momentum investing is also known as “position trading”, while medium-term momentum trading is referred to as “swing trading”. Speaking of duration and different types of trading considering the length of time you hold a position, you should also know that day trading, a term used in comparison with swing and position trading is the short-term form of momentum trading.
Long-term investing vs Momentum trading
The purpose of long-term investing focused on fundamental facts, as explained above, is to “buy low, sell high”. On the flip side, the purpose of momentum trading is to “buy high, and sell higher”.
Momentum trading strategies you should know
In momentum investing, a rule of thumb is that a stock reaching a record high is likely to exceed it. To find momentum stocks, you could use a stock screener to identify those stocks that trade within 5%-10% of their 52-week highs, for example.
Usually, traders apply their own criteria for identifying momentum stocks (i.e., small companies, volatility, volume, time frame). Many traders use chart patterns and indicators to spot them. Read on to learn more about these criteria and how to use them with momentum investing.
Volatility rocks the charts. Defined as the degree whereby an asset’s price changes over time, volatility describes a market’s stability status. A market with high volatility is characterised by dramatic price swings, while a low volatility market is more stable (and less exciting for momentum traders).
Typically, momentum traders are attracted by moderately to highly volatile markets, seeking to capitalise on the short-term price peaks and declines. As volatility is one of the main drivers of momentum trading, it is essential to have a proper risk management strategy to protect your capital against contrarian market movements. Using stop and limit orders are also a good way to mitigate risk.
Volume represents the amount of an asset traded within a specified period or time frame. It is important to note that volume does not represent the number of transactions carried out through the trading platform involving the asset in question but the number of assets traded. For example, if five investors buy one Tesla share each, it is recorded as if one investor acquired five Tesla shares.
Volume is essential to momentum investors, as they seek to enter and exit trades quickly, which depends on a stable number of buyers and sellers. The higher the number of buyers and sellers, the more liquid the market is. The lower the number of buyers and sellers, the less liquid the market is considered.
As explained above, momentum trading relies on short-term price movements. However, the duration you hold a position depends on how long the trend remains strong. From this perspective, momentum trading is a versatile trading strategy suitable for both long and short-term traders like scalpers, for example.
Indicators used with momentum trading
As fundamental analysis comes secondary in momentum trading, traders are mainly concerned with price action and technicals. Some of the commonly used indicators used in this type of trading are the Intraday Momentum Indicator (IMI), the Relative Strength Index (RSI), Moving Averages (MAs), and the Stochastic Oscillator.
The Intraday Momentum Indicator (IMI)
The IMI is momentum investors’ favourite indicator, as it takes into account the most recent closing price and compares it with the previous closing price. This makes it perfectly suitable for traders seeking to determine the strength of a trend.
Classified as an oscillator, it is represented as a single line moving from and to a centreline of zero (or 100 sometimes). The value provided by this indicator clues traders about how frequently a price is changing. If, for example, the IMI reads 45, it means the uptrend is stronger against a previous reading of 39. In contrast, if it reads -17, it means the downtrend is stronger than a reading of -15.
The Relative Strength Index (RSI)
The RSI is often used to provide buy and sell signals. Like the IMI, the RSI is plotted on a different chart below the price chart, represented by a line moving from zero to 100.
It is also an oscillator, and it helps traders identify overbought or oversold market conditions. In general, if the RSI shows a reading of 30 or below describes an oversold or undervalued market condition. In contrast, a reading of 70 or above describes an overbought or overvalued market condition.
Used with the momentum strategy, the RSI helps traders spot retracements between these price levels (the 30 and 70 areas) and determine clear trends. Momentum traders typically open and close positions within the trend, not at the top or bottom.
It is important to note that even though the RSI may signal overbought or oversold tendencies in an asset, it does not mean that the trend will reverse any time soon. This is why it is critical to use the RSI in combination with other indicators, such as Moving Averages or the Stochastic Oscillator, for greater precision.
Moving Averages (MAs)
Traders use moving averages to identify new trends. Generally, MAs are used by momentum traders to determine whether a market is rangebound or not since MAs filter out fluctuations to indicate a prevailing price trend.
The commonly used MAs are 15-day, 25-day, 35-day, 50-day, and 100-day. If the shortest-term MA is plotted on top of the longer-term one, it means the trend is gaining speed.
Most importantly, when using moving averages, bear in mind that they are a lagging indicator; hence, any signals will materialise after the price moves. For greater precision, it is advisable that use MAs in combination with other indicators.
When the MAs cross, it means a trend reversal is about to take place (as soon as the price declines).
The Stochastic Oscillator
The Stochastic Oscillator is used to compare the last closing price with the previous trading range within a specified time frame. Interestingly, this indicator does not follow price direction or volume. Instead, it is sensitive to the momentum and speed at which price changes occur. In doing so, the Stochastic oscillator is suitable for predicting price movements.
It consists of two lines plotted on the price chart:
- Indicator line- the rangebound line that oscillates between zero and 100. A reading above 80 typically indicates an overbought market condition. Comparatively, a reading below 20 signals an oversold condition.
- Signal line- a line plotted onto the price chart. If the signal and the indicator lines cross, it means a significant change in direction is likely to occur.
Typically, if the Stochastic doesn’t fall back to the 20-mark during a pullback, it means the trend will continue upward.