Understanding and trading the dynamics of market momentum can be a daunting task, however, by employing specific strategies, traders can increase their chances of success. One such strategy is momentum trading, which capitalizes on the momentum of price trends in various assets. Let’s delve into the world of momentum trading and how traders use this approach to identify and leverage profitable opportunities. We will explore key concepts, indicators, and practical examples, shedding light on this popular trading strategy.
What is Momentum Trading?
At its most simplistic core, price momentum is the notion that price trends continue more often than they reverse, so following the trend will be, statistically, a smarter choice. Most traders will agree that momentum trading and trend trading are safer approaches, but, in reality, the markets are unpredictable, and no fixed forecasting methodology can be right every time. Keep that in mind when testing momentum trading and let that knowledge influence your trading budget accordingly.
Notably, while momentum trading is commonly associated with stock trading, it is also popularly used to trade other asset classes.
The momentum trading indicator
To see the momentum indicator in action, register your email address to get immediate access to the Exness Terminal. Use the available demo account to get familiar with the momentum trading indicator risk-free. On the Exness Trading Terminal, at the top left, you can find a drop-down menu with over 100 top-rated indicators. Search “Momentum” and select from the list to lay the momentum indicator below the chart. It’s that easy. So what does the momentum indicator show?
The momentum indicator measures the rate of change in a stock's price. Typically, the momentum of a stock's trend slows before it changes direction. If the momentum indicator crosses the zero line, momentum traders consider this a possible entry or exit signal.
In line with the momentum trading strategy, traders entering a position when the momentum indicator crosses above the zero line might hold the position as long as the indicator stays above. When the momentum indicator crosses below the zero line, momentum traders take that as an indication that momentum is falling and the current trend is coming to an end. If the momentum indicator stays above 0, then a trader typically holds the order open, but when the indicator crosses 0 once again, a trader will consider an immediate exit.
Top tip: It all sounds easy, but keep in mind, not all crossover points are reliable entry or exit signals. This is because the momentum indicator can generate numerous signals as it crosses above and below the zero line.
To help reduce the number of entry and exit signals, consider using additional conditions as a filter. Such filters include applying price patterns or examining the overall trend of the broader stock market. Momentum trading is deeply rooted in technical analysis. Spotting a trend on a chart displaying strong momentum is not so easy using the naked eye, although some traders with 3 to 5 years of trading experience sometimes can. For momentum traders in need of help, indicators are the obvious choice, and there are 3 indicators that momentum traders commonly rely on.
Top 3 momentum trading indicators
Most traders overlay indicators for a more precise analysis, and 3 indicators are by far the most commonly used by momentum traders.
- Relative Strength Index (RSI)
- Moving Average Convergence Divergence (MACD)
- Stochastic Oscillator
Relative Strength Index (RSI)
The RSI is a popular indicator with momentum traders. RSI measures the speed and change of price movements. On your Exness Trading Terminal, click the indicators button at the top left then search “RSI” and select Relative Strength Index. On the bottom of the chart, you’ll see a range chart starting at 0 and rising to 100. RSI strategy suggests any asset with a reading above 70 indicates an overbought situation, which is said to result in a slowing of momentum and even a reversal.
Likewise, readings below 30 indicate an oversold status, which can precede the end of a bearish momentum.
Moving Average Convergence Divergence (MACD)
The MACD indicator is also helpful when analyzing momentum. The MACD consists of two lines: the MACD line and the signal line. When the MACD line crosses above the signal line, it generates a bullish signal indicating a potential momentum shift. Conversely, when the MACD line crosses below the signal line, it generates a bearish signal indicating momentum change. The distance between the MACD line and the signal line also reflects the strength of the momentum. Traders often use MACD in conjunction with other indicators to make informed trading decisions.
The Stochastic Oscillator measures the momentum of price by comparing the current closing price to its price range over a specific period. This indicator generates values between 0 and 100, with readings above 80 considered overbought and readings below 20 considered oversold.
Trading tips for momentum traders
There is no foolproof method of trading, but momentum trading or trend trading is considered to be a more reliable approach than waiting for reversals and trading the swings. Traders should also consider analyzing and comparing market sectors and individual stocks to identify potential opportunities when momentum trading. For example, if big tech stocks are performing well, lesser-known tech companies may display bullish reactions as interest saturates the sector.
If the indicators, sector sentiment, chart patterns, financial news, and fundamentals confirm momentum, it’s time to enter the market. Exit points are not so easy. Momentum traders have dozens of theories when it comes to plotting exit points, but a good rule of thumb is not to let emotion, sentiment, or greed influence your decision.
If the asset displays periodic volatility, then consider setting Stop Loss and Take Profit not far from the asset price range. If you’re planning to keep an order open for over a week, look back on the range over the last month. Keep your expectations realistic, and be stringent about loss limits. It’s better to take a small loss and have equity for the next trade.
Lastly, some of the most drastic reversals occur without any indication or warning from the charts. If you miss out on some of these dynamic price actions, don’t beat yourself up, and don’t let losses influence your next trade. Approach every new trade and every new day with a calm analytic mind and perform due diligence without bias.
Momentum Trading FAQs:
Here are a few frequently asked questions about momentum trading.
- What is momentum trading? Momentum trading is a strategy used by traders to take advantage of the continuation of existing price trends in various assets. It involves identifying assets with strong upward or downward movement and capitalizing on their momentum for potential profits.
- How do traders identify trends and price momentum? Traders identify trends and price momentum by analyzing price charts and looking for patterns of consistent upward or downward movement. They may use technical analysis tools and indicators to confirm trends and gauge the strength of momentum.
- What role do indicators play in momentum trading? Indicators are essential in momentum trading as they help traders confirm trends, identify potential entry and exit points, and assess the strength of market momentum. Popular indicators include the Relative Strength Index (RSI), Moving Average Convergence Divergence (MACD), and Stochastic Oscillator.
- How can market sectors and stocks be assessed for momentum trading? Traders can assess market sectors and individual stocks for momentum trading by analyzing the overall trend within sectors and selecting stocks that demonstrate strong momentum within those sectors. This increases the probability of finding assets with high momentum and profit potential.
- How do traders establish entry and exit points in momentum trading? Traders establish entry and exit points with indicators and chart patterns. Price targets and trailing stop-loss orders are commonly used to protect profits and limit potential losses.
- What is the importance of risk management in momentum trading? Risk management is crucial in momentum trading as it helps traders protect their capital and minimize potential losses. Traders should employ proper position sizing, set stop-loss orders, and have a clear understanding of their risk tolerance to manage risks effectively.
- Examples of momentum trading? Practical examples of momentum trading can include identifying stocks that have experienced a significant breakout or breakdown, using indicators to confirm the momentum, and entering trades accordingly. Traders may also look for stocks with strong trends in specific sectors and capitalize on their momentum.
- Is momentum trading suitable for all traders? Momentum trading requires active monitoring, technical analysis skills, and a willingness to take on higher levels of risk. It may not be suitable for all traders, especially those with a more conservative or long-term investment approach. Traders should assess their own risk tolerance and trading style before engaging in momentum trading.
- Are there any drawbacks to momentum trading? Like any trading strategy, momentum trading has its drawbacks. One potential drawback is the possibility of false signals or sudden reversals, which can lead to losses if not managed properly. Additionally, high volatility and rapid price movements can increase the level of risk associated with momentum trading.
- Can momentum trading be combined with other strategies? Yes, momentum trading can be combined with other strategies and approaches. Some traders employ a multi-strategy approach, combining momentum trading with a trend following, mean reversion, or fundamental analysis. The key is to develop a trading plan that aligns with one's trading style and objectives.