Momentum Trading: What you Need to Know

Today I felt I should write something about momentum trading.

I thought this is something you should have some knowledge of as a trader since momentum trading is highly influenced by recent price trends. 

As a trader, you are always subjected to risk any time you take a position, and as a result, it is always good to know what you are getting yourself into before embarking on any form of trading. 

So,

What is Momentum Trading?

Momentum trading is a process where you buy and sell depending on the strength of recent price trends

Price momentum is like momentum in physics, where mass multiplied by velocity controls the possibility of an object continuing on its path. 

However, momentum in trading is determined by other aspects such as the rate of price changes and trading volume. 

Momentum traders bet that the price of an asset moving strongly in a certain direction will keep moving in that direction until the trend loses strength.

We can further classify momentum readings into two different categories: relative momentum and absolute momentum. 

Relative Momentum vs Absolute Momentum

Relative Momentum

Market behaviors in the prices of certain securities are put in contrast with one another to show relative strength that distinguishes strong-performing assets from weak-performing securities.

Absolute Momentum

Market behavior in the price of an asset is centered on the relationship it has with previous performances using historical time sequences.

Factors Affecting Momentum in Trading 

Volatility

Volatility is very important for momentum traders. 

It is the degree of change in the price of an asset, whereby a market with high volatility signifies huge price changes, while a market with low volatility signifies stability.

Momentum traders lookout for volatile markets so as to take advantage of short-term increases and decreases in the value of an asset. 

While momentum trading tries to maximize on volatility, it is important to have a good risk management strategy ready to protect your trades from serious market movements as well as stops and limits.

Volume

This is the amount of a specific asset that is traded at a certain period of time. 

Volume is not the number of transactions but the number of traded assets. In this case, if five buyers each purchase one asset, the result appears to be the same as if one buyer purchases five assets. 

Volume is important to momentum traders because they should be able to enter and exit positions quickly, and this depends on the existence of a stable chain of buyers and sellers in the markets. 

When a market has a large number of buyers and sellers, it is referred to as a liquid market because it is easier to exchange one asset for another. 

On the other hand, when a market has a few buyers and sellers, it is referred to as illiquid.

Time Frame

Momentum trading strategies are normally centered on short-term market movements.

The duration of a trade can, however, be influenced by how long the trend maintains its strength

This could be good for traders using longer-term styles like position trading and those who like short-term styles, like day trading and scalping.

Though I have realized momentum day trading is more common than the rest.

Price Action or Indicators for Momentum Trading?

You can execute momentum trading using both indicators and price action. 

With indicators, you will be looking for entry signals being provided by your indicator of choice. There are several that you can use, and you will find out as you continue reading. 

When it comes to price action, momentum trading is more dependent on the reading of candlesticks.

For you to identify momentum via candlesticks, you need to ascertain the length of the candlestick coupled with the opening and closing prices. 

Every candlestick tends to tell a story regardless of the timeframe involved. Here, you will have an idea of whether it is the buyers or sellers who are winning the battle as this dictates the direction of the market. 

Momentum Trading Indicators

Relative Strength Index (RSI)

RSI measures the strength of the present price movement over recent times. 

The goal is showing if the trend is stronger than the previous performance.

Moving Averages (MA)

These averages are helpful in identifying overall price trends and momentum through smoothing what we may see as unstable price movements on short-term charts into visual trend lines that are easy to read. 

We get the averages by adding the closing prices over a given number of periods and then dividing the result by the targeted number of periods. 

They can be simple moving averages or exponential moving averages that offer greater weight to more recent price action.

Moving Average Convergence Divergence (MACD) 

MACD is a chart indicator that compares the movement of quick and slow exponential moving market average trend lines against a signal line.

This shows price momentum as well as possible price trend reversal points. 

When the lines are farther apart, then momentum is strong, and when the lines are converging, momentum is slowing, and price may move toward a reversal.

Commodity Channel Index (CCI)

This momentum indicator is used to compare the “typical price” of an asset or the average of high, low, and closing prices alongside its simple moving average and mean deviation of the typical price. 

Just as stochastics and other oscillators, its purpose is to show overbought and oversold conditions. 

Readings above 100 show overbought conditions, while readings below 100 show oversold conditions.

Average Directional Index (ADX)

This oscillator tool purely focuses on determining trend momentum. It sets the strength of a price trend on a graph between values of 0 and 100. 

The values below 30 show sideways price action and an undefined trend, while those above 30 show a solid trend in a certain direction. 

When the value is approaching 100, the momentum of the trend is believed to get stronger.

Stochastics

The stochastic oscillator is used to compare the current price of an asset with its range over a certain period of time. 

When the trend lines in the oscillator get to oversold levels, they show an existing upward price momentum. 

While in overbought levels, they show a downward price momentum ahead.

Stochastic Momentum Index (SMI)

 This tool is a model of the original stochastic indicator.

 It measures the position of the present close as per the midpoint of a current high-low range, offering a notion of price change regarding the range of the price.

 Its goal is giving an idea that a reversal point is close or whether the current trend is likely to continue.

Building Block

 With this, traders share an existing chart into equal periods, separated into blocks. The blocks are then each given a color depending on whether they show an upward or downward trend.

For instance, blue for upward and yellow for downward.

 A third color, green, may be used to show a sideways trend. 

When the chart shows two consecutive blocks with similar colors, then it means that there is momentum in a given direction.

On Balance Volume (OBV)

This is a momentum indicator used to compare the trading volume to price. 

Its fundamental basis is that when trading volume rises significantly without changing much in price, it shows a strong price momentum.  

On the other hand, if volume decreases, it shows a weak momentum.

Momentum Trading Using Chart Patterns

Below are examples of momentum trading strategies through the use of chart patterns. 

In this case, I will focus on the bull flag and flat top breakout patterns. 

Bull Flag

Bull Flags tend to be many people’s favorite charting pattern (based on the interactions that I have had previously).  

I tend to understand why since this pattern can be seen almost every day in the market, and it provides low-risk entry points into strong markets, i.e., forex trading, stocks among others.

For several newbie traders, the most difficult part is identifying these trends/patterns in real-time. 

You ought to be looking for trends that sustain continued momentum as a trend-driven trader. With time you tend to develop the ability of detecting patterns on charts with ease.

The entry trigger should be the first candle to make a new high after the breakout in the Bull Flag pattern. 

In an example where you are trading stocks, you will look for stocks that are squeezing up, creating the tall green candles of the Bull Flag, and then wait for a pullback with several red candles.

Your entry should be the first green candle to create a new high after the pullback, with the stop loss at the pullback’s low. 

When the first candle makes a new peak, you will normally see a spike in volume. 

Hundreds of thousands of retail traders are taking positions and placing buy orders.

Flat Top Breakout

The flat top breakout pattern is similar to the bull flag pattern, except that the pullback usually has a flat top with high resistance, as the name suggests.

 This generally occurs over a few candles, and the obvious flat top pattern on a chart will make it easy to see.

This pattern typically develops when there is a large seller(s) at a certain price level, requiring buyers to buy before prices can continue to rise. 

When short sellers see this resistance level forming, they can place a stop order just above it, which can result in an explosive breakout.

When buyers break through the resistance level, all buy stop orders will be triggered, causing the market to rapidly rise, and longs will be sitting on some nice profits.

Always know that you are at liberty to choose whichever momentum trading strategy that works for you.

Don’t try to stick with a trading strategy that does not suit you because that is what the “gurus” are advocating for. 

Is Momentum Trading Risky?

These are the kind of questions that I tend to say are subjective to some extent.

 Similar to other types of trading, momentum trading has its risks. 

It is common to achieve success when prices follow a trend, but with momentum trading, traders can be caught unaware. This is because there is a major focus on breakouts. 

This takes place when trends move into unforeseen reversals. 

Traders should therefore keep a few factors in mind and adopt them. Technical analysis centers its findings on the possibility of price movements on past price trends.

It is possible for prices in the market to move in an unforeseen direction at any time. 

This is because of unexpected news events, as well as fears and changes in sentiment in the market.

Does momentum trading work? This is up to you to confirm. But the fact that this form of trading has been in existence for a long time and is backed by varied studies should tell you all you need to know. 

Conclusion

There is always a debate on whether to use indicators or naked charts for momentum trading.

This is my take;

Beyond what can be seen simply by looking at the trading charts, the momentum indicators won’t provide much detail. 

The price chart, as well as the momentum indicator, will show the direction that the price is moving aggressively.

Momentum indicators may be useful for detecting small changes in the force of buying or selling. 

Instead of being used to produce trade signals on their own, the indicators are better used to help validate a price action trading strategy.

On my part, I always advocate for the use of price action by way of reading naked charts. 

This aspect helps you to comprehend what is going on in the market. 

You are able to identify areas of interest where the market is likely to react with ease as you continue to practice. 

The fact that you are able to tell what most traders are thinking at a certain period, you will easily avoid pitfalls like stop hunts being executed by the “big boys” in the market. 

As a result, I would encourage you to use naked price action when dealing with momentum trading as opposed to the use of indicators. You can maybe use indicators as confirmation tools for naked chart analysis rather than your primary entry signal.

You should always have this in mind when momentum trading stocks, forex, or any other market of your choice.   

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