Many people have asked me what momentum trading is and how it differs 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. So 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 toward it. For the love of God, you will 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 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.
Momentum Trading Factors
Humor me briefly 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. As a result, 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.
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 the price will likely continue on its current trajectory.
Like a wave that builds and falls, the price movement reaches a maximum peak. After this point, buyers recede, sellers start selling their positions, and the price tends to flatten or reverse 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
What is momentum trading, and how does it work? It’s like its name suggests. You’re trading the momentum of a stock. For example, if you’re shorting a stock, you want to buy high and sell low. Then buy low and sell high if you’re bullish on the stock. The idea is to get out of stock right before the momentum changes.
Relative Strength Index (RSI)
As you can see by the name, RSI measures a trend’s strength. RSI tells us when to enter and 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.
Stochastics
What the stochastic oscillator does is compare 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.
MACD
This indicator compares fast- and slow-moving EMA trend lines against a signal line. The result is the same: 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
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 its name suggests. You’re trading the momentum of a stock. For example, if you’re shorting a stock, you want to buy high and sell low. Then buy low and sell high if you’re bullish on the stock. The idea is to get out of stock right before the momentum changes.
Fantastic Momentum Trading Strategy
Have you heard of the bull flag momentum trading strategy? If not, you’re in luck, as I will tell you all about it.
Bull flags are 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 momentum traders, 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 its peak. Instead, the pros wait to enter as momentum builds.
The hourly chart shows the hourly candles have been ripping above the nine-day exponential moving average from the DAILY time frame. So yes, we use TrendSpider to view how hourly candles react to daily moving averages, and we can spot bull flags and look more closely at where we want to get long or close our trades.
Don’t Chase the Wave
One golden rule all successful traders follow is that they don’t chase stocks. Luckily, if you missed the first wave entry, swim around and wait to enter during the next consolidation period.
You can pull the trigger and begin buying when the stock price breaks out of the consolidation area. 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, the price has likely been over-extended for a while now, which means buyers will soon lose control.
I refuse to enter for fear of momentum and interest waning. However, avoiding trades after the second consolidation is a smart rule, and you’d be wise to adopt it.
I highly suggest you invest significant time learning 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.
Frequently Asked Questions
Momentum trading is a legitimate trading strategy if you're looking to capitalize on quick moves on stocks intraday. Traders use their trading account as leverage to grow their account while making several trades intraday.
Momentum trading is still a profitable trading strategy if you manage risk and don't get greedy. Most momentum traders are not successful, but if you do it right, you can make a lot of money.
The 11 am rule means that if the market hasn't had a trend reversal by 11 am EST, then it's less likely to have a significant reversal throughout the rest of the trading day.
Momentum trading involves the buying and selling of volatile securities intraday. Traders are looking to capitalize on large price moves on the same day. Swing trading involves buying and selling securities over weeks and months, while capitalizing on larger trend moves and reversals.
Momentum trading and scalping are similar trading strategies. Scalp traders typically have tight price targets and look to capitalize on a small piece of a stock's move. Momentum traders are looking to capitalize on the meat of the move.
