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Momentum trading: what is it and how do you use it?

By Zoran Temelkov

This strategy offers the chance to generate high profits but there could be a higher level of costs

Momentum trading: what is it and how do you use it?

What is momentum trading?

Momentum trading is a strategy used by traders to define entry and exit positions based on the underlying asset price strength. It is based on the idea that a price which is increasing will tend to move even further upwards, or when the price is falling it can continue its decrease. So, momentum traders try to identify securities which exhibit strong momentum and the possibility for the price to persists with its movement in the same direction.

The price momentum can be a base for opening positions because periods of increasing prices attract buyers who put upward pressure on the price. And when the prices fall, sellers are attracted and the pressure from the additional sellers may push the price further down.

Essential elements in momentum trading or factors affecting the price momentum are the volatility, volume and time frame.

The asset's volume represents the quantity of the particular assets which have been bought and sold on the market for a specific period. An adequate level of volume would be an indication that there is enough demand and supply for the particular asset and the traders can easily buy or sell the asset.

Volatility represents the size of the price changes for a given asset and wider price swings could mean that the potential profits to be made are higher but also the potential losses can be higher. This is where momentum traders will pay special attention because they want to make profits through increase volatility when prices increase or fall in a short period. To minimise their potential losses, which may arise from the higher volatility, traders can place stop-loss points.

Momentum trading strategies are commonly considered as short-term strategies but you can hold your position for a longer period if the momentum continues. This means longer-term traders can also use momentum trading.

Types of momentum

There are two types or methods for measuring the price momentum of an asset. They differ in terms of the bases for analysing the current price momentum and the anticipation for it in the future.

  • Absolute momentum refers to the notion that market behaviour is reflected in the asset's price through its relation with the price movements in the past. Put simply, the absolute momentum compares the price momentum to itself.
  • Relative momentum is a method in which the price momentum of individual assets is evaluated against the price momentum of other individual assets.

Popular momentum indicators

Traders can use a variety of technical analysis indicators to measure or estimate the market momentum. Usually, they are oscillator indicators which can fluctuate within a bound or can be unbounded. The main purpose of using momentum indicators in your trading strategy is to gain insight into the speed at which the price moves in the trend direction, determine entry or exit points or identify potential trend reversals.

Momentum indicator is a leading oscillator indicator applied by traders to detect potential overbought or oversold market conditions as well as the strength behind the current trend.

Stochastic oscillator – the calculation of the indicator is based on the last closing price and the high-low range for the period. The indicator is shown as two lines moving within the 0 to 100 range and traders can determine overbought (the line is above 80) or oversold signals (the line is below 20).

Commodity channel index measures the typical price (which is the average from the high, low and closing price) for a given period in relation to the moving averages and the mean deviation of the average price. As it is the case with some other indicators, traders can identify overbought market conditions (when CCI is above 100) or oversold levels (when CCI is below -100).

Moving average convergence divergence (MACD) is a technical momentum indicator which considers two exponential moving averages (faster EMA and slower EMA) and a signal line. The MACD indicator is used by traders to identify not only the price momentum but also to detect potential trend reversals.

There are many other momentum indicators you can use to define trading strategies. Try to find the best combination of indicators for identification and validation of trading signals.

Your momentum trading strategy will depend on the technical indicators, the candlestick patterns or both. When defining strategy, look for potential buy or sell signals through the respective crossover's strategies. The aim is to try to find specific histogram formation or price bars formation or wait for a divergence to appear between the price movement and the indicator.

Momentum trading strategies

The momentum trading strategy can be based on pullbacks, which means that you will be waiting for a temporary pullback from the primary trend to enter your position. Some traders consider the resistance and the support levels when trading pullbacks, in a sense that the initial resistance levels become the new support levels and vice versa.

Another strategy which can be used is the momentum breakout strategy which is applied for detecting entry signals. Using the momentum strategy traders try to identify potential breakout patterns when the price will move outside the resistance or support level and the opportunity to determine the trend direction. When looking at the breakout strategy, you want to see long bullish or bearish candlesticks which move above the resistance or below the support line. The identified candlestick is referred to as momentum candlestick. Look at the following example:

The graph shows the potential buy signal determined through the momentum breakout strategy. Look at the momentum candlestick which breaks out the resistance level – after that the price continues its upward movement. Traders can open a long position when the momentum candlestick closes. Of course, you can define other breakout patterns in their strategy, depending on the instrument traded and the technical indicators used.

Momentum trading candlestick strategy

Your momentum trading strategy can also include price action. Try to identify candlestick (or bar) patterns or candlestick momentum to detect potential entry and exit positions. Consider the length of the candlestick and the opening and closing prices. There are numerous patterns which you can try to find and also you can estimate the momentum in different ways. One way to see whether the candlestick is losing its momentum is to examine whether the pullback is 50 per cent of the bar range.

Traders can also determine whether the price loses momentum by looking at multiple consecutive bars. If for example, the bars are becoming smaller, but they move in the same direction than it could be a sign of diminishing momentum. So, if you decide to trade based on price action you need to understand the meaning of the different candlestick forms.

Things to consider when applying momentum trading

  • Define assets selection criteria so that you can decide which securities will be adequate for this type of trading strategies. You can specify a level of volume, the degree of volatility, etc, which should be fulfilled by an asset before you consider it for trading.
  • Well defined risk management principles.
  • Carefully define your stop loss strategy.
  • Define a risk-reward ratio and use it in your trading strategies.
  • Try to find a trend.

Advantages of momentum trading

  • It provides an opportunity for generating high profits in a short period when traders open their position on time.
  • Traders benefit from market volatility because traders will execute a momentum trading strategy for assets with an adequate degree of volatility.

Disadvantages of momentum trading

  • There could be a higher level of costs due to the higher turnover.
  • Traders should ensure that they know what is happening with the price and the momentum to be able to exit the position at the right moment.

FURTHER READING: How to read trading charts

FURTHER READING: How to read and use moving average indicators

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