What is Momentum Trading and its Key Indicators? How Does it Work?
Momentum trading is a strategy that traders use to capitalise on the market trends pertaining to a particular stock. Traders who study the momentum of the stock prices try to make money by going along with the price trend in a given direction. Momentum traders use multiple strategies and tools to identify stocks that show high chances of earning substantial returns owing to an ongoing trend.
Read on to learn how momentum trading works, factors of momentum trading and the steps to start this type of trading.
What Is Momentum Trading?
Simply put, momentum trading strategy is the practice of making money by capitalising on price trends. Events like earnings reports or changes in directorial boards can cause such price trends. However, certain momentous stocks follow long-term uptrends, particularly owing to their high value.
Every asset price has its own direction and speed. Depending on what affects price trends, traders may buy several assets at their rising stages and sell them on anticipating a peak. The sufficient force behind a price move can help traders make more money. Proponents of momentum trading believe that identifying the winning stocks is as important as selling the losing stocks (downward or random price movements).
How Does Momentum Trading Work?
Momentum stock trading works on the principle of buying-high-selling-higher. Thanks to market volatility, traders can take advantage of short positions in an upward-trending stock. Several indicator signals show the price at which the stock can peak. Once traders anticipate the signs of the peak, they can sell that stock at a higher price to gain substantial returns.
Expert investors believe that 20-30% of stocks have the potential to move upward in value. Short-term asset price movement is possible when other factors remain constant.
For example, when the number of stocks investors intend to buy is higher than the number of available stocks, stock prices undergo uptrends. In addition, macroeconomic factors like industry conditions affect company management, together with market sentiment, can move stock prices.
Also Read: What is Position Trading? What are its Types, Advantages and Risks?
What Are the Factors of Momentum?
The momentum of price uptrends depends on three key factors:
• Asset Volume
Volume defines the amount of traded assets in a timeframe. Since momentum trading involves quick entry and exit from the held positions, asset volume denotes a steady stream of buyers and sellers. A high asset volume of a particular stock represents a higher volume of trading.
• Asset Volatility
Volatility defines the degree of an asset’s change in price. Highly volatile markets represent larger price swings in comparison to a stable market. To take advantage of rising price changes, options and momentum traders prefer markets with higher volatility. However, suitable risk management is necessary to handle such enormous price movements.
• Trading Timeframe
Momentum traders trade on short-term price movements depending on the trend strength. However, position traders may choose long timeframes, while day traders and scalpers prefer shorter timeframes.
What Is the Process to Start Momentum Trading?
Momentum trading primarily involves the following five steps:
Step 1: Identify the high momentum stocks for intraday or position trading.
Step 2: Use indicators and statistical analysis to understand the price trends. These trends will help define a trading strategy.
Step 3: Study the factors or events that prompt sharp price changes.
Step 4: Open an account with an online trading platform and buy the desired units of the asset.
Step 5: Look for the peak of the uptrend and sell your intraday momentum stocks at a higher price.
What Are Momentum Trading Strategies?
Momentum traders base their trading decisions on fundamental analysis. As a result, they can choose various strategies for trading momentum.
• Filtering Rising Stocks
Since rising stocks can rise even further, try screening all relevant stocks that rise at a particular rate.
• Trading with Technical Indicators
Statistical data gives a great opportunity to understand an asset’s market potential. They help to determine the volume and volatility of stocks via chart patterns.
• Trading with Market News
Sudden market changes can provide a sharp positive reaction in terms of stock prices. Traders using this strategy can identify more critical momentum ideas depending on their expertise and anticipation.
How to Start Momentum Trading?
To become a momentum trader, it is important to understand the various aspects of intraday trading. Individuals require expertise in anticipating sudden price changes and market fluctuations so that they can buy and sell assets at the right time to gain maximum profits.
Apart from finding the right stocks at the right time, it is important to learn how various trading charts work. The charts help in the technical analysis of the price of the stocks. Lastly, traders must know when to exit a trade. Studying various exit indicators will help you to make an informed decision.
Popular Momentum Indicators
The price action of an underlying asset defines its profit-making prospects. In addition, technical and statistical analysis helps traders determine an asset’s growth. Some widely used indicators include:
• Momentum Indicator
This indicator compares the recent closing price of an asset with its previous closing price, thereby identifying its strength. As an oscillating indicator, it records the price movements along a centre line. This oscillator gives an idea of the rate at which the price is rising. Higher indicator reading could mean greater chances of an uptrend.
• Relative Strength Index
Traders use this indicator to obtain buying and selling signals. Like the momentum indicator, RSI is also an oscillating indicator. Its values determine the overbought and oversold signals that trigger traders to take appropriate action.
• Moving Averages
Sometimes, traders may want to identify emerging price trends. Instead of using an oscillating indicator, they filter out random fluctuations to reveal the actual price trend. Moving average indicators determine whether a market is rangebound.
• Stochastic Oscillator
Stochastic indicators compare an underlying asset’s most recent closing price with its previous trading range. Over time, this indicator gives a clear idea of the speed and momentum of the market trends. As a leading indicator, it can form the indicator line that oscillates between 0 and 100, showing the overbought and oversold stocks. A signal line alerts traders of a particular market shock. The intersection of these lines guides a trader into buying or selling decisions.
Risks and Drawbacks of Momentum Trading
The primary drawback of momentum trading is a trader’s inability to identify a price change correctly. Since trend reversals are common, uptrend momentum often does not last long. Identifying the peak of a price movement is also tricky. Some other potential risks of trading with momentum include:
• Breakouts in Momentum Trading
Breakout trading involves identifying a range that triggers potential trades. However, momentum intraday trading involves trading with an upward price movement. Therefore, incorrect timing can result in false movements.
• High Stock Turnover
Traders face exorbitant fees for high stock turnovers. Most momentum traders find it difficult to manage such high costs despite the low-price consensus.
• Time Intensive and Market Sensitive
Monitoring market details is time consuming. Since momentum trading closely follows crest and trough movements, any abrupt update can deter buyers. Bull markets are in better positions for momentum trading because they are less market sensitive.
Also Read: What is Derivative Trading? How Does it Work?
Final Word
Momentum trading involves identifying rising price trends. It is one of the most popular trading strategies that traders use to identify opportunity pockets. Although it has chances of generating high returns, momentum traders should always be on the lookout for abrupt market changes. Knowing when to enter and exit a trade requires expertise that momentum traders must be familiar with.
FAQs
Ans. Stocks that undergo rapid price movements over a short time-frame are high momentum stocks. Most intraday traders tend to avoid such stocks owing to their high levels of risk. Although these stocks have the potential to generate high returns, they can also crash unexpectedly.
Ans. Traders use price difference information to identify a stock’s momentum. For example, a 15-day momentum is a difference between the closing price 15 days ago and the last closing price. Traders can also know the momentum of a particular sector or industry by using this method.
Ans. Momentum trading can be highly profitable if a trader can anticipate the sudden price changes and act accordingly. Novice traders who are comparatively new to the world of intraday trading should familiarise themselves with the trading charts and price patterns before they start momentum trading.
Ans. Momentum trading can lead to high profits in shorter timeframes. Momentum traders can use the strategy of “buy high and sell higher” to earn substantial returns in a short time. However, this requires extensive knowledge about market sentiments and price movements.
Ans. Momentum options trading is the strategy that options traders use to buy options contracts of underlying assets that have a rising price trend and then sell the contracts when the prices have peaked. Momentum option traders primarily look for underlying assets that showcase short-term price uptrends.
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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
