Momentum Trading: Strategies for Success

Introduction

Do you remember the mathematics class where you learned the concepts of distance, speed, and time? Let’s take you down the memory lane with this example. 

Suppose A and B are two sailors. While A is sailing at 20 km/h upstream, B is sailing at 20 km/h downstream. The speed of the stream is 5 km/h. Don’t worry! We are not asking you to calculate the distance or speed—just the concept.

What separates the two is the trend and momentum. If these two were racing, who would you bet on? B, right? This is the concept of momentum trading.

In trading terminology, going downstream shows the trend, the speed of the current shows the momentum, and the speed of B is the volume that supports this momentum. 

This blog comprehensively explains the concept, momentum trading strategies, and how you can benefit from it.

Understanding Momentum Trading

It is the strategy that looks to capitalize on the existing trends in the market that are expected to continue in the short term. In this strategy, a trader will research and find the stocks:

• that are rising and have the potential to rise further in the short term or
• that are falling and have the potential to continue falling in the short term

Once the stocks moving in one direction are identified, you should look for the volumes. If both trend and volumes support the momentum, you can trade in the direction of the trend until there are clear signs of trend reversal.

As a trader, you should study technical momentum indicators and the charts of the stocks to identify the trend and make decisions.

Precepts of Momentum Trading

While there are no rules to momentum trading, here are the generally accepted standards that traders follow:

• Price Movements: The foundation of this trading strategy depends on the directional movement of a stock’s price. Hence, you should identify the stocks that show strong momentum in one direction.
• Confirmation: How would you confirm whether your assessment is correct and the stock will keep moving in the same direction? Here are 3 things you should check:
  • Trend Following: The price should show a continuous trend in one direction.
  • Relative Strength: The stock should show a stronger momentum than its peers and the overall market.
  • Volume Analysis: A trend should be considered strong only if it’s supported by high trading volume.
• Quick Decision Making: As momentum trading is a short-term strategy, you should identify the trend and decide to capitalize on it.
• Risk Management: However carefully you have analyzed, there is always a risk of the price moving against your analysis. To mitigate this risk, you should have your stop-loss order in place. 

Also Read: Insider Trading

Elements of Momentum Trading

Here are the elements that affect the outcome of the momentum trading strategy:

Technical Indicators

Short-term traders use these technical momentum indicators to check the effectiveness of the trend:

• Moving Averages: Usually, traders use 50-day and 200-day moving averages to identify the direction of the trend.
• Relative Strength Index (RSI): RSI measures the speed and change of price movements. By studying this indicator, you can judge whether a stock is overbought or oversold.
• MACD (Moving Average Convergence Divergence): MACD shows the relationship between 2 moving averages. It can signal a trend reversal.

*Note: The convergence between the 20-day and 50-day exponential moving average is called “The Golden Cross”. It is used as one of the traders’ strongest indicators of trend reversal.

Chart Patterns

Traders use chart patterns as technical analysis tools that show the market patterns and trends.

• Breakouts: If a stock breaks the support or resistance levels with huge volumes, it is called a breakout. It shows a strong trend in one direction.
• Continuations: Patterns that show the continuation of the current trend are used by traders to identify momentum trading opportunities. For ex. Flags and pennants.

Volumes

If high volumes accompany a trend, it shows a strong momentum. Hence, these are used as indications of future price movements.

Market Sentiments

Many traders take positions in the market based on the news. Hence, the market sentiments can shape the momentum. While positive news shapes an upward momentum, negative news shapes a downward momentum.

To learn more about important trading strategies that you can apply while trading, explore our courses!

Benefits of Momentum Trading

• High-Profit Potential: You can generate significant profits if you identify the right momentum trading opportunity and execute your plans at the right time.
• Clear Entry & Exit Points: By studying the technical indicators and charts, you can identify the best entry and exit points signals.
• Flexibility: Momentum trading strategies are relevant across markets. You can apply the concept in stocks, forex, and commodities markets.
• Reduced Emotional Trading: Since it is strategy-driven trading, there is no chance of you falling into the trap of emotions that will lead to bad decisions.

Drawbacks of Momentum Trading

• High Risk: Every trade carries risk, including the possibility of the trend reversing suddenly. Markets are unpredictable and can always beat our expectations.
• Requires Constant Monitoring: As short-term trades are prone to higher volatility, it is important to regularly monitor the movements and developments. Traders can adjust their positions according to these changes.
• Potential for Overtrading: Due to the fast-paced nature of momentum trading, it is highly prone to overtrading. If you enter into too many trades, it can increase the transaction costs and reduce the profits considerably.
• Dependence on Market Conditions: Momentum trading strategies can only be applied when there is a trend-based momentum. If the markets move sideways and are unclear, you cannot apply this strategy.

Conclusion

Momentum trading is a profitable trading strategy that can yield substantial benefits. Usually, traders use this strategy to gain the benefit of short-term price momentum. If you understand how the strategy works, you can benefit by using the momentum trading strategy for intraday trading. However, keeping the right approach and mindset and following the stop loss is advisable to avoid the risk of heavy losses.

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