What is momentum trading?
In Physics studies, the word Momentum is used to state an object’s quantity and route of motion. Likewise, in business markets, momentum is defined as an asset‘s direction and swift price change in the market.
Momentum trading is a practice in which traders buy and sell depending on recent price trends' strength. In this method, the user analyzes assets for the short term and buys assets whose prices are rising. Once the price appears to have peaked, you can sell those assets and make a profit. According to this concept, the price will move in a specific direction if enough force is behind it.
Moreover, Price momentum is similar to momentum in physics, where mass multiplied by velocity determines a given object's likelihood of continuing on its trajectory. Momentum traders bet that an asset price will continue to move powerfully in a given direction until it loses its momentum.
Short-term, high-risk trading strategies like momentum trading require a lot of skill and practice. The term is related to trades held for one day or several days on average, although momentum trades go long when trends remain strong.
By identifying the trend in a security's price action and predicting its near-term future movements, momentum traders try to exploit the market.
The method to momentum trading madness is to seek an entry point when prices fall and then determine an exit point when prices become overbought. You can also use short strategies to profit from market downturns when using momentum trading. In a sense, this type of trading is quite simple. Momentum trading is categorized in two ways:
Relative Momentum and Absolute Momentum
Relative momentum and absolute momentum are two categories of momentum trading.
Comparing the performance of various securities within an asset class is known as relative momentum, and investors will favor buying strong performing securities and selling weak performing securities.
An absolute momentum strategy compares the price of a security with its previous performance over a while.
It is easy to use absolute or relative momentum when trading currencies. Absolute momentum is more commonly associated with momentum trading strategies.
How does Momentum Trading Work?
The fundamentals of momentum trading are to choose security (such as a stock or ETF), identify a trend, and then execute a plan to profit from the trend as it continues shortly.
To achieve this goal, several factors need to be considered. Volatility, volume, timing, and technical indicators are a few examples.
Volume
During a certain period, the volume represents the number of units of a particular asset bought and sold (for example, the number of shares of stock). A large amount of volume is necessary for traders to make profits. If there is not enough volume, slippage can occur.
Slippage occurs when the number of shares being sold at a trader's price point isn't sufficient to fulfill the order all at once. As a result, multiple orders are placed, each slightly lower than the previous one, resulting in a smaller profit. As long as the volume of orders is high enough, this won't happen, as most orders can be handled at once at the same price point.
Time Frame
The difference between successful traders and unsuccessful ones lies in their plans. Momentum trading occurs most often on a short time frame, though not always as short as day trading. Unlike day traders, who may hold a position for hours or even minutes, momentum traders may hold thispositions for a day, several days, or even longer.
Volatility
Volatility refers to how frequently and how significant price changes occur. Short-term traders tend to enjoy volatility because it offers opportunities for large profits in a short amount of time. Volatility, however, entails risk as well. In fact, high volatility is often an indication of high risk in an asset.
Technical Indicators
Analysis of charts can be used to predict price movements in the future through technical analysis. Based on various mathematical formulas, traders can use charting software to determine how a specific asset's price has performed. Indicators are used to determine how an asset has performed.
Investors attempt to predict the near future for security based on one or more of these indicators. Nevertheless, short-term traders need to have this tool in their arsenal. What is the appearance of these indicators?
The Relative Strength Index is the simplest technical indicator. An indicator such as this is designed to show how a stock has performed recently based on its closing prices during a given period.
The RSI provides a numeric value between 0 and 100. Higher values indicate security has been overbought, while lower values indicate security has been oversold. Also, a low RSI can be an indication to buy, while a high RSI can indicate to sell. This article is far too short to cover all aspects of technical analysis.
Indicators of momentum are commonly used to determine a particular asset's momentum. The price of an asset can be visualized with graphical tools, such as oscillators, that show how it's moving and how long it will move in that direction. When new investors or money enters a particular trade near its peak, the velocity of the price movement reaches a maximum. This is the idea behind the tool. After a peak, the price trend tends to flatten or reverse direction if there is less potential new investment.
The direction of momentum can be determined by subtracting the previous price from the current price. It signals a positive momentum when a positive result, while it signals a negative momentum when an impact is negative.
Momentum trading indicators divided by an earlier price are referred to as a rate-of-change indicator (ROC). Multiplying this total by 100, traders can find the ROC percentage to plot highs and lows on a chart. It is more likely that the price trend will weaken and reverse as the ROC approaches one of these extremes.
Traders commonly use a few technical indicators to track momentum and determine when to enter or exit a trade within a trend.
Moving averages: It can assist in identifying overall price trends and momentum by smoothing what may appear to be erratic price movements on short-term charts into visually clear trend lines. To calculate them, add the closing prices of a given number of periods over a given number of periods, then divide by the number of periods considered. Simple moving averages give greater weight to more recent price movements than exponential moving averages.
Relative strength index (RSI): This measure indicates how strong the current price movement has been over the past few months. A strong trend is determined by comparing the current trend with the previous one.
Stochastics: Stochastic oscillators compare an asset's current price with its range over a specified period of time. A reading below twenty on the oscillator's trend lines indicates an upward price momentum is imminent. A task that reaches overbought conditions-typically above 80-signals an impending decline in price.
Moving average convergence divergence (MACD): Analyzing exponential moving price averages against a signal line on a chart, this indicator compares fast- and slow-moving trend lines. In addition, it indicates possible price trend reversals. Momentum is strong when the lines are farther apart, and slowing momentum suggests a possible reversal when they are converging.
Commodity channel index (CCI): In this indicator, the "typical price" of an asset is compared to a simple moving average and the mean deviation of the typical price of an asset. It shows overbought and oversold conditions, just like stochastics do. An overbought reading is greater than 100, while an oversold reading is more significant than 100.
On balance volume (OBV): Measures volume about price. The idea behind it is that when trading volume increases significantly without a huge price change, it indicates strong price momentum. We understand a decrease in volume as a sign of declining momentum.
Stochastic momentum index (SMI): Stochastic momentum index is an improved version of the traditional stochastic indicator. By comparing the current close with the midpoint of a recent high-low range, the price change can be gauged is concerning the price range. Doing so aims to indicate whether a reversal point is near or if the current trend is likely to continue.
Average directional index (ADX): The purpose of this oscillator is to determine the trend momentum. It plots a price trend between zero and one hundred: a less than 30 indicates sideways action and an undefined trend, whereas a value higher than 30 indicates a clearly defined trend. The momentum of the trend gains strength as the value approaches 100.
Building block: Using this technique, an existing chart is divided into equal periods, separated by blocks. The blocks are then color-coded according to whether they indicate an upward or downward trend. For instance, green indicates an upward trend, and red indicates a downward trend. There is a third color, yellow, that may be used for sideways trends. There is momentum in a given direction when two consecutive blocks have the same color.
Momentum trading strategies
Momentum can be measured over long periods, such as weeks or months, or over short periods, such as minutes or hours.
Traders typically decide on the direction of the trend they want to trade as their first step. After establishing an entry point by using one of the many momentum indicators available, they can then trade (or sell) the asset. As well as determining a good and reasonable exit point for their trade, they will rely on projected and previously observed levels of support and resistance in the market.
The stop-loss orders should also be set above or below the entry point of the trade, depending on the direction of the trade. In order to protect against an unexpected price-trend reversal and unwanted losses, this precaution is taken.
Investors and traders use momentum to take advantage of rising or falling trends in a stock's price. Momentum trading strategies involve some risk and require a high degree of accuracy. Due to the momentum already behind these trends, momentum-style traders believe they will continue in the same direction.
Trend traders
By looking at price momentum, you are likely to consider stocks and ETFs that have been going up continuously for several weeks or even months at a time. It can be difficult to get into markets that make new highs. Nevertheless, it is essential to know that evidence shows that markets making new highs have a tendency to make even higher highs.
Keep an eye on volatility
There is a higher degree of volatility associated with momentum trading than with most other strategies. By taking advantage of volatility, momentum trading seeks to maximize returns. Investing in the stock market incorrectly can result in significant losses. When momentum traders lose a trade, they usually use a stop loss or other risk management method to minimize losses.
Ways to find price trends
Stocks and ETFs that trade within 10% of their 52-week highs are a good indicator of the top stocks and ETFs. You could check change in price over the past 12 or 24 weeks. That method is usually more indicative of price changes in recent weeks.
Oil and energy were an excellent example in mid-2008. Despite collapsing, it was still ranked among the top sectors based on its 12-week or 24-week price performance. Over many weeks, even a big pullback got lost within the more enormous run-up that preceded it, since the gains were so large in the first half of the 12- or 24-week periods.
A shorter-term price change measure, such as a 1-week or 4-week measure, may be helpful for spotting trends early. Investing in and selling an ETF or stockworks in the same way.
Pros and cons of momentum trading
Momentum trading has the main advantage of bringing profits in a relatively short amount of time when done correctly and consistently. Momentum traders can turn out profits weekly or even daily, unlike buy-and-hold investors, who may take months, years, or even decades to see significant returns.
In contrast to long-term investing, momentum trading centers on technical analysis of charts rather than understanding the fundamentals of each investment. Although this method of trying to predict price movements is by no means perfect, it keeps things simple. In contrast to grasping the bigger picture, traders focus on a single lens.
Momentum trading is, in this respect, simpler. Comparatively to long-term investing, short-term trading involves a lot more buying and selling, which allows for more opportunities for mistakes.
The other way to pursue momentum strategy is to capitalize on the volatile nature of the market and its trends. A momentum investor looks for stocks that are in the process of climbing the ladder and then sells those stocks at their peak prices to profit the most. These investors lead the pack when the trend hits the market to maximize their returns.
Cons of Momentum Trading
Momentum trading involves a lot of risks, as mentioned. Momentum traders attempt to predict future price movements based on the actions of other market participants. A single press release or fundamental development can knock this off-balance completely, but it can also work.
Suppose, for instance, that a momentum trader finds a strong upward trend in the share price of a telecommunications company, call it Company A.
An imaginary trader develops and implements a plan, buying a stock when it dips at a specific price point. Let's say we are planning to sell the stock once it reaches a long-term resistance level.
Historically, the hypothetical trader has made a nice profit on this trade many times, so company A expects it to be no different this time around.
A surprising event then occurs. A rival telecommunications company, calls as Company B, issues a press release after the next trading day when profits are to be booked on a continuing price rise.
The new technology implemented by Company B will greatly benefit customers, and it has pulled ahead of Company A. Investors fear that company A will lose clients to company B as a result of this.
Any trends identified by technical analysis in this hypothetical scenario would have been quickly invalidated. The real markets encounter scenarios like these every day.
In addition, momentum trading requires the investors to analyze trends, and the trade will be detailed. Consequently, the market must be pursued with a lot of spare time. News announcements in the market need to be watched closely.
Also, prior to implementing a momentum strategy, extensive research is required. In order to analyze buy and sell signals, it is essential to have an understanding of general market functioning and different indicators.
Final Thought
An important concept for determining the likelihood of a profitable trade is momentum. Measures of momentum are helpful in all types of trading strategies, as they can be applied short-term and long-term. It is possible to use several technical trading tools to determine whether a trade on a particular asset is a good investment.
Market participants should be aware. However, that momentum projections are generally based on past price trends. The actual momentum and price can change at any moment due to events not considered in the original calculations.
Real-time News
