Many people have asked me what is momentum trading and how is it different from other types of trading. I think it's a great question because momentum trading is a fantastic strategy to add to your trading toolbox.
Keep reading to discover what momentum trading is, how it works and four popular momentum-based indicators you can use to get started.
What Is Momentum Trading?
- Have you ever tried surfing? Well, momentum trading is exactly like surfing. You sit on your board, hang out, bob around the ocean and wait. And wait some more. All of a sudden, you see it coming in the distance. The wave is building rapidly; you snap into action, paddling like a crazy person towards it. For the love of God, you're going to nail this wave and ride it before the momentum (wave) dies out.
For those of you who surf, you know the importance of timing; paddle too slow and miss the crest, stand up too fast, and the wave blows over you. And that my friend is momentum trading.
Summed up, it's is a strategy in which you use the strength of price movements to determine your trade entry and exit points.
Those who trade on momentum take advantage of market volatility (i.e. the ocean waves) by entering when prices are going up and selling them as the wave crashes down again.
1. What Factors Determine Momentum?
Humor me for a minute and think back to your high school physics classes. Do you recall talking about momentum?
Or, where mass multiplied by velocity determines the likelihood that an object will continue on its path? Similarly, trading price momentum is just like momentum in physics.
However, in financial markets, other factors like trading volume and rate of change determine momentum. Momentum traders go out on a limb and bet that an asset price moving strongly in one direction will continue to move in that direction until the trend loses strength.
2. Popular Momentum Trading Indicators
Momentum trading indicators show you how quickly the price of a given security is moving in a particular direction. They can also tell us whether or not the price is likely to continue on its current trajectory.
Like a wave that builds and falls, the price movement reaches a maximum peak. After this point, buyers recedes, sellers start selling their positions, and price tends to flatten or reverse in direction.
Below are a few technical trading oscillators commonly used by momentum traders to decide if the time is right to ride the wave.
Moving averages: Ultimately, moving averages help you identify price trends and momentum using smoothing price lines. Instead of erratic short-term price moves, moving averages give you a nice smooth chart. There's no size fits all approach to using moving averages; you can use simple moving averages or exponential moving averages.
Relative strength index (RSI): As you can see by the name, RSI measures a trend's strength. RSI tells us when to enter and when to exit the market by telling us whether it is overbought, oversold, flat or range-bound. To calculate RSI, we take the average gain of up periods during a specified time frame divided by the average loss of down periods. More importantly, the resulting number will tell us if a reversal is imminent.
3. Indicators Continued
Stochastics: What the stochastic oscillator does is compares the current price of an asset with its range. Typically a number below twenty means an upward moment is at hand. Conversely, a number above 80 means a reversal is coming on the horizon.
Moving average convergence divergence (MACD): This indicator compares fast- and slow-moving EMA trend lines against a signal line. The end result is the same as above: identification of price momentum and reversal point. We consider momentum to be strong when the lines are far apart. The opposite is true for converging lines; momentum is slowing down, and the price will likely move toward a reversal.
On balance volume (OBV): Finally, the OBV indicator directly compares trading volume to price. The underlying principle is that price momentum is strong when trading volume rises significantly without a significant price change. Alternatively, we interpret a decrease in volume as a sign of diminishing momentum.
How Does Momentum Trading Work?
- What is momentum trading and how does it work? It's like it's name suggests. You're trading the momentum of a stock. You want to buy high and sell low if you're shorting a stock. Then buy low and sell high if you're bullish on the stock. The idea is to get out of a stock right before the momentum changes. Our online trading courses will teach you how to do just that.
1. One Fantastic Momentum Trading Strategy
Have you heard of the bull flag momentum trading strategy? If not, you're in luck as I'm going to tell you all about it.
Luckily, bull flags are quite easy to identify if you know what you're looking for. Like a flag, bull flags have a pole. Within the pole are several large rising candles, and a flag, or a series of small candles moving sideways.
As a momentum trader, we look to time our entry before the crest of the wave hits. This "before" period is the series of candles moving sideways. Smart traders don't buy at the top of the wave when the price is at it's peak. The pros wait to enter as momentum builds.
2. Don't Chase the Wave
One golden rule all successful traders follow is they don't chase stocks. Luckily, if you missed the first wave entry, swim around and wait to enter during the next consolidation period.
As soon as the stock price breaks in the consolidation area, you can pull the trigger and begin buying. More often than not, a stock will show several consolidation periods. But that doesn't mean you should enter.
As a rule of thumb, I only enter during the first and second consolidation periods. After that, price likely has been over-extended for a while now, which means buyers will soon be losing control.
I absolutely refuse to enter for fear of momentum and interest waning. Avoiding trades after the second consolidation is a smart rule, and you'd be wise to adopt it.
Where to Go From Here?
I highly suggest you invest a significant amount of time learning how to use the various momentum indicators. By learning how to spot a momentum change, you can position yourself on the winning side of a trade.
We can't teach you how to surf, but we sure as heck can teach you how to ride the momentum wave.