What is Momentum Trading? Definition and Strategies

What is momentum trading? With electronic trading gaining popularity, this is a question that often comes up from novice traders. In this article, we've provided a comprehensive definition of what momentum trading is and when it should be used.

What is Momentum Trading?

Momentum trading is a strategy based on buying and selling assets with the aim to profit from ongoing trends in the market and capitalize on market volatility. A trader will enter into a position in the direction of the primary trend, and then ride that trend until it shows signs of reversal. The goal is to enter into trades at key points in the trend in order to maximize profits.

A momentum trader will buy stocks and assets when their price is rising and sell them when the price starts falling. The goal for a momentum trader is to correctly identify when a trend is about to continue so that they can enter into or exit from a trade accordingly. As opposed to the common trading philosophy "buy low, sell high", momentum trading is focused on "buying high and selling higher". The idea is to follow price trends and "sell losers" (items with prices going down) and buy winners (items with prices going up). 

How Is It Calculated?

Momentum is defined as the rate of change in price over a given period of time. Momentum can be calculated using the following formula:

Momentum = Price (t) - Price (t-n) 

where t is the current time and n is the number of days over which momentum is being calculated.

History of Momentum Trading

Momentum trading has been around for centuries. One of the earliest examples of momentum trading was during the 18th century when Japanese rice traders used a momentum strategy to buy and sell rice.

In the early 1900s, momentum trading strategies were developed by traders such as Jesse Livermore and W.D. Gann. These traders believed that prices tended to move in cycles and that it was possible to make money by trading in the direction of momentum.

Momentum strategy really took off in the 1980s when personal computers and charting software became widely available. Traders could now easily access data and create charts to identify momentum patterns.

One of the most famous momentum traders is George Soros. In 1992, Soros made over $1 billion by betting against the British Pound. He did this by selling short the currency when he noticed that it was losing momentum.

Nowadays, traders can use many different types of momentum trading strategies to try and profit from the markets. Some common momentum indicators include the MACD, RSI, and Stochastic Oscillator.

When Momentum Trading Should be Used?

A few key indicators that a momentum trader will look for before entering a trade. These include:

• the price of the asset moving in an upward or downward direction

• the trading volume of the asset

• recent news about the asset

• the overall trend in the market

When a momentum trader observes that multiple technical indicators are all pointing in the same direction, they will probably enter into a trade. For example, if they notice that the price of an asset is going up and the trading volume is high, they will buy the asset. However, if they see that the price is falling and the trading volume is low, then instead they will sell the asset.

Momentum Trading Risks 

Momentum trading can be a successful strategy for any type of trader. However, it is important to note that it is not without its risks. And one of the biggest risks is missing the start of a new trend. If a momentum trader enters into a trade too late, they may find themselves on the losing side of the trade.

Another risk to consider is that momentum can sometimes carry an asset price further than what may be considered rational. This can lead to momentum traders holding onto a losing position for too long in the hopes that the momentum will continue and they will be able to exit the trade at a profit.

Day Trading and Momentum Trading

Momentum trading is a popular strategy that many traders use to take advantage of rapid price changes in the market. It relies on predicting future price movements based on past price movements instead of other strategies such as technical analysis or fundamental analysis. To minimize potential losses, most momentum traders employ stop loss or another risk management strategy.

Day trading is a strategy where a trader buys and sells an asset within the same day. The goal of day traders is to make profits by taking advantage of the small price changes in the market.

However, there are some key differences between momentum and day trading.

1. First, momentum traders may hold onto their positions for days or weeks, while day traders will only hold positions for a matter of hours.

2. Second, momentum trading often relies on technical indicators to spot trends, while day trading may also use fundamental analysis to find stocks that are undervalued or overvalued.

3. Finally, momentum trading may involve higher risks and potential rewards than day trading.

Both momentum trading and day trading can be profitable if done correctly. However, each strategy has its own risks and rewards that should be considered before entering the market.

Pros and Cons of Using Momentum

Momentum trading is a strategy that seeks to capitalize on the continuance of existing trends in the market. A momentum trader enters into a position that will profit from an anticipated continuation of the price trend, rather than from changes in the direction of price. The key to successful momentum trading is correctly identifying which markets are most likely to continue their current trends.

There are a number of advantages to momentum trading. First, it can be a very profitable strategy if used correctly. A well-executed momentum trade can result in significant profits. Second, momentum trading can help traders avoid many of the pitfalls that plague other types of trading strategies. For example, because momentum traders are only interested in the continuation of existing trends, they are not as likely to be caught off guard by sudden changes in market direction.

There are also some disadvantages to momentum trading. One is that it can be a difficult strategy to master. In order to be successful, momentum traders must have a strong understanding of technical analysis and be able to correctly identify which markets are most likely to continue their current trends. Another disadvantage of momentum trading is that it can be a very risky strategy. A poorly executed momentum trade can result in substantial losses.

Overall, momentum trading is a potentially profitable but risky trading strategy. It can be difficult to master, but if done correctly it can lead to significant profits.

So, let's sum up the pros and cons of this type of trading:

Advantages of momentum trading include:

• The ability to take advantage of both short-term and long-term trends

• The potential to make quick profits from trades

• A relatively simple strategy to implement

• It can be adapted to different timeframes, meaning that traders can use them on a variety of timeframe charts

Disadvantages of momentum trading:

• Difficult to master

• Requires knowledge of technical analysis

• High risk/reward ratio

• Can lead to substantial losses if not executed correctly

Momentum Trading Strategy

There are a few different momentum strategies that traders can use:

The MACD Crossover Strategy

This is one of the most popular momentum trading strategies. This strategy uses the MACD (Moving Average Convergence Divergence) indicator to identify when a trend is about to continue.

1. The MACD indicator is calculated by subtracting the 26-day Exponential Moving Average (EMA) from the 12-day EMA. A 9-day EMA of the MACD is then plotted on top of the MACD line to act as a signal line.

2. A buy signal is generated when the MACD line crosses above the signal line. This indicates that momentum is about to pick up and the price is likely to continue to rise. A sell signal is generated when the MACD line crosses below the signal line. This indicates that momentum is about to slow down and the price is likely to fall.

3. The MACD Crossover strategy can be used on any timeframe from 1-minute to monthly charts. The most popular timeframes for this strategy are 5-minute, 15-minute, and 30-minute charts.

The Stochastic Oscillator Strategy

The Stochastic Oscillator, a momentum indicator, is used to predict when a trend will continue. This strategy employs the oscillator to create buy and sell signals.

1. The Stochastic Oscillator is calculated by subtracting the closing price from the 14-day low and dividing this number by the difference between the 14-day high and the 14-day low. The resulting number is then plotted on a scale of 0 to 100.

2. A buy signal is generated when the Stochastic Oscillator crosses above the level of 20, indicating that momentum is about to pick up and the price is likely to continue rising. A sell signal is generated when the Stochastic Oscillator crosses below 80, which means momentum might soon stall and prices are more apt to decrease.

3. The Stochastic Oscillator Strategy works best with 5-minute, 15-minute, and 30-minute charts.

The Relative Strength Index (RSI) Strategy

The Relative Strength Index (RSI) is a momentum indicator that is used to identify when a trend is about to continue. The RSI Strategy uses the RSI to generate buy and sell signals.

1. The RSI is found by taking the 14-day average of gains, subtracting the 14-day average of losses from it, and then dividing this number by the difference between these averages. This number is plotted on a scale from 0 to 100.

2. An indication to buy is usually given when the RSI crosses above 50, meaning that momentum will soon pick up and prices are destined to keep climbing. A signal to sell appears when the RSI falls below 50, implying a deceleration of momentum and a probable decrease in price forthcoming.

3. The RSI Strategy is optimal for 1-minute to monthly chart usage. However, the 5-minute, 15-minute, and 30-minute charts are the most popular among users.

How to Start Using Momentum in Your Own Trades

Momentum trading can be a great strategy for novice traders to use. However, it is important to remember that this type of trading comes with a higher risk/reward ratio. This means that while you have the potential to make large profits, you also have the potential to lose a lot of money if you do not execute your trades correctly. 

The key is to always do your research and never risk more than you can afford to lose. You should learn how to read charts, spot trends, and make smart decisions. Different trading tools and platforms can support these efforts and help you trade successfully. 

Basics of Momentum Trading to Bear in Mind

1. Momentum traders enter into a position when the price of an asset is moving in a constant direction. The objective is to profit from the trend until it eventually changes direction.

2. A crucial aspect of momentum trading is to always have stop-losses in place. This will shield you from heavy losses if the market reverses course rapidly.

3. It's important to always be mindful of the different market conditions when trading. Momentum trading is most successful in trending markets but can be quite risky in range-bound or choppy markets.

4. Finally, don't get too caught up in the short-term movements of the market. Remember that momentum trading is a long-term strategy and you should only enter into positions when you're confident that the overall trend is still intact.

What Trading Software to Use?

There are a number of different software platforms available to traders and you should check at least the most popular ones to see which suits your needs best. Most of them offer a number of features that are specifically designed to help traders take advantage of market momentum.

Some of the key features of platforms you should be looking for:

• Advanced charting

• Real-time market data and news feeds

• A wide range of order types

• Flexible position sizing

Before you make a decision on which platform to use you should check their websites, existing tutorials, and possible webinars, and try maybe even a demo account. 

No matter what type of trading strategy is applied, what all the trading platforms have in common is powerful software such as TimeBase or RTMath that is in charge of feeding the platform with data necessary for traders to make the right decisions. 

The Bottom Line

Momentum trading has the potential to be quite profitable. However, it's important to remember that this strategy involves higher risks and rewards. This means that while you have the opportunity to make significant profits, you also face increased chances of losses if your trades are not carried out correctly.