Momentum Trading: How Does It Work? And What Is It?

 

Momentum trading is a popular strategy that most traders use as part of their trading strategy.

 

It uses the strength of stock price movements as a foundation to open positions. The strategy seeks to use momentum to enter a trend as it picks up steam.

 

This blog gives you complete information on momentum trading, how it works, and popular momentum-based indicators and strategies to get started.

 

If you don't have a share trading account yet, consider eToro, used by many investors in Australia and worldwide. You can create an eToro trading account HERE.

 

eToro AUS Capital Ltd ACN 612 791 803 AFSL 491139. OTC Derivatives are speculative and leveraged. Not suitable for all investors. Capital at risk. See PDS and TMD

 

eToro offers extensive trading features, social trading tools, and copy trading to imitate the trades of other famous traders.

 

 

1. What Is Momentum?

 

Momentum refers to the speed at which a stock's price is changing.

 

It reflects the tendency of a price trend to persist, whether going up or down, over a defined period, taking into account both trading volume and price data.

 

In technical analysis, momentum is primarily assessed using an oscillator and serves as a valuable tool for recognizing and understanding market trends.

 

 

2. What Is Momentum Trading?

 

Investors can incorporate stock price momentum into their trading strategy to capitalize on the market psychology's tendency towards herd behavior and profit accordingly.

 

Momentum traders try gaining returns by buying stocks that trend one way or another. The practice attempts to earn by trading stocks along with a trend.

 

One of the momentum trading examples is - If the stock soars after a stellar quarterly earnings report, you, as a momentum trader, should try purchasing shares and ride the stock's price higher.

 

It continues until several sellers enter the market. Once there are enough sellers, the momentum changes direction and reduces the asset's price.

 

Additionally, a stock's price can begin rising due to a rumour. In that case, momentum traders might buy shares in anticipation that the short squeeze will increase the stock's price.

 

Momentum investing is a technical strategy that relies on fundamental performance metrics like earnings and revenue, with a primary focus on using past stock prices as a key technical indicator.

 

 

3. How Does Momentum Trading Work?

 

Momentum investing relies on technical indicators that are based on fundamental performance metrics like earnings and revenue. The primary technical indicator favoured by momentum investors is historical stock price performance.

 

Traders who use this strategy seek to place a trade to capitalise on an expected stock price change and exit the trade once the trend loses its strength.

 

Momentum trading allows traders to determine the speed of change in an asset's volume or price. Momentum is mainly an oscillating measure, as stock volume or price doesn't follow one direction indefinitely.

 

As a momentum trader, you should aim to benefit from stock price action rather than its long-term fundamentals and growth. A few critical indicators that momentum trading uses are the momentum indicator, Moving Averages, the RSI, and the stochastic oscillator.

 

 

 

4. Fundamental Elements Of Momentum Investing

 

When trading momentum in stocks, you need proper risk management to address overcrowding, hidden traps, and volatility that reduce profits.

 

Here are the key elements that constitute the concept of momentum investing:

 

 

Volatility

 

It is the degree to which an asset price can change. A highly volatile market indicates big price swings; however, a low volatility market is comparatively stable.

 

Momentum strategies mostly struggle in the side-ways market or when the stock's share price trades sideways. Most momentum strategies for buying stocks work best in bullish market phases.

 

 

Volume

 

Volume is crucial for momentum traders, who can enter and exit positions quickly. A market with many buyers and sellers is called a liquid market. Such markets make it easier to sell an asset for cash.

 

 

Time Frame

 

What is the best timeframe for momentum trading? Momentum trading strategies are primarily focused on short-term market movements. However, the trade duration can depend on the period the trend maintains its strength.

 

It is appropriate for traders who implement longer-term trading techniques like position trading and those who prefer short-term trading techniques like day trading.

 

Early positions yield the maximum reward with the least risk; however, aging trends should be discarded at all costs.

 

 

 

5. Should A Beginner Do Momentum Trading?

 

Momentum trading is a widely adopted strategy among short-term traders.

 

Like any trading approach, it necessitates a certain level of market knowledge and practice before implementation, and momentum trading is no exception.

 

This trading method is straightforward and user-friendly, but it does demand a solid grasp of stock data and trends to make informed predictions about potential price movements based on historical performance.

 

 

6. What Is An Example Of A Momentum Trading Strategy?

 

If a stock's price goes up from $100 to $150, momentum traders buy it, thinking it will keep going up based on market trends.

 

Conversely, traders go short if the stock drops from $100 to $80, betting that prices will fall further. So, the concept is straightforward, but technical analysis is crucial to time their trades effectively and minimize trading costs.

 

As any trading strategy involves risks, beginner traders must be aware of its dangers, the volatility of financial markets, and the impact of macroeconomic events on the market before implementing this strategy.

 

 

7. What Types of Securities Are Best Suited for Momentum Trading?

 

• Momentum strategies are effective with growth stocks because companies with unique appeal can rise hundreds of per cent. Your profit potential from momentum strategies can increase if you identify price movement early and then make gains as they grow higher.

• Liquid securities are suited when engaging in momentum strategies. Regular funds make great trading vehicles but lead to smaller percentage losses and gains than individual securities.

• Looking for securities with over 5 million shares trading daily is better. Many popular stocks meet this criterion, but less volatile stocks can become a highly liquid instrument. This happens due to the news flow and intense emotional reactions from diverse market sources that trigger fast movement from one price level to another.

• Pay attention to new products, ideas, or business areas that really catch people's interest and make analysts reevaluate how much money they think a company will make.

 

When a momentum investor consistently follows these rules, they improve their chances of achieving success.

 

 

 

8. Advantages Of Momentum Trading

 

Momentum trading is a potentially profitable strategy that seeks to capitalise on market volatility by purchasing rising stocks and selling them when the market shifts.
 

It works well for traders with the right personality who can handle the risks and are dedicated to sticking to the strategy. Here are a few benefits of momentum trading:

 

• Potential to generate substantial profits in shorter periods

• Able to use the market's volatility to maximise return on investment.

• Leverages the decisions of emotional investors to capitalise on stock price changes. 

 

 

9. What Are The Disadvantages Of Momentum Trading?

 

Similar to other trading styles, momentum trading carries its share of risks.

 

Understanding these risks will enable you to make the most of this strategy while safeguarding your investment from potential drawbacks:
 

• Momentum investors are at risk of timing a stock purchase incorrectly and ending up underwater. 

• Price trends are never guaranteed, as there could be unexpected market corrections or reversals due to surprising news or changes in investor sentiments.

• You may not make profits if you enter into a position too early before a momentum move is confirmed. Exiting the position too late after price saturation reaches. Missing reversals, changing trends, or news that surprises the market. Failing to exit quickly from a wrong position, thereby riding the momentum trend incorrectly.

• Carrying your position the next day may cause the trade to turn in your favour. This happens because stocks are prone to external factors, and keeping positions open overnight can cause radically different patterns and prices the next day.

• Momentum investing demands substantial time and continuous market monitoring. This is essential because investors aim to identify stocks that surge and then retreat, necessitating quick entry and exit decisions.

• Momentum investing is sensitive to market trends. It often works best in a bull market with more buyers and sellers. The profit margin on momentum trading reduces as investors get alerted.

 

 

 

10. Steps To Begin Momentum Trading In Australia

 

Now that you've grasped the concept, fundamentals, and strategies of momentum trading, let's take a closer look at the four main steps to begin your momentum trading journey:

 

1. Find the asset that interests you.

2. Develop a momentum trading strategy using technical indicators and analysis.

3. Use a demo trading account to practise trading and gain confidence in a risk-free environment. 

4. Set up a trading account to begin trading on live markets.

 

If you don't have a share trading account yet, consider eToro, used by many investors in Australia and worldwide. You can create an eToro trading account HERE.

 

eToro AUS Capital Ltd ACN 612 791 803 AFSL 491139. OTC Derivatives are speculative and leveraged. Not suitable for all investors. Capital at risk. See PDS and TMD

 

eToro offers extensive trading features, social trading tools, and copy trading to imitate the trades of other famous traders.

 

 

 

11. How To Become A Profitable Momentum Trader?

 

Momentum trading is a highly "active-trading" strategy traders use in stocks, commodities, currencies, or other financial markets. It thrives on significant short-term price fluctuations and volatility, creating potential profit opportunities.

 

A momentum trader constantly monitors the market for trading opportunities and executes trades swiftly to cash on short-term price movements. They depend on the following to find potential entry and exit points and seize price momentum effectively:

 

• Technical analysis, including indicators such as relative strength index (RSI), volume, moving averages, and 

• Trading strategies like breakout trading, momentum oscillators, and trend-following.

 

To be successful in this trading style, you must have a mix of discipline, in-depth knowledge of market dynamics, and skills. These traders follow a disciplined approach, strict risk management strategies, pre-define stop-loss levels and profit targets.
 

However, it's essential to understand that since markets constantly change, a backtest can only determine the effectiveness of momentum trading for a specific asset.
 

 

12. What Are The Most Popular Momentum Trading Strategies?

 

Momentum traders make use of several strategies; the popular ones are as follows:

 

 

Price Action Momentum Trading Strategy Backtest

 

 

For Stocks:

 

• When the closing price of a stock goes above its 100-day high, traders initiate a long trade at the closing price. Conversely, if the closing price of the stock falls below the lowest close price in the past 100 days, traders enter a sell trade at the closing price.

 

 

For Crypto:

 

• When the closing price of a cryptocurrency exceeds its 25-day high, traders initiate a long trade at the closing price. Conversely, if the cryptocurrency's closing price falls below the 25-day high, traders open a short position at the closing price.

 

 

 

Sector Rotation Momentum Strategy ETFs

 

Another effective strategy involves measuring the ETF's performance to determine which assets to buy the next month based on their monthly momentum.

 

 

Spot Divergences in Price Action

 

Traders use the Relative Strength Index indicator and Four-hour chart to identify divergence in price action.

 

This occurs when the price consistently moves in one direction, while the RSI indicator forms lower highs, indicating the onset of a reversal in the opposite direction.

 

 

Determining the Asset's Trend Momentum with ADX, Daily Chart, and 200 Moving Average

 

The Average Directional Index (ADX) and 200 moving average confirm the formation of trend momentum in an asset.

 

As the ADX value rises above the asset's 200-period moving average, it indicates a strengthening bullish or bearish trend in the underlying price trend.

 

 

13. What is The Most Popular Momentum Strategy?

 

Popular momentum trading strategies involve using technical indicators and studying chart patterns to determine the correct entry and exit point and capitalise on trends.

 

A popular momentum strategy is to identify stocks that hit a new high. The reason is that such stocks will likely continue their uptrend and reach even higher levels.

 

Running a stock screener is the simplest way to find such momentum stocks. Small companies with high volume and unusually high volatility are good contenders for momentum trading.

 

Other momentum trading ideas include watching out for stocks in earnings season, following the news feeds, and waiting for the stock to abruptly rise based on news.

 

 

 

14. What is The Most Popular Momentum Indicator?

 

Rather than worrying about the fundamentals of the underlying asset, Momentum traders generally care about its price action. That's why most rely heavily on technical analysis and indicators to determine each trade's correct entry and exit.

 

Listed below are some popular and efficient technical indicators to help you succeed in your momentum trading strategy:

 

 

The Momentum Indicator

 

The indicator considers a stock's most recent closing price and compares it with its previous closing price. It helps identify the strength of a trend.

 

 

The Relative Strength Index (RSI)

 

It is an oscillator that helps predict the future market direction on a scale from zero to 100.

 

It shows whether momentum is increasing or decreasing and how overbought or oversold an asset is. A reading above 70 implies an overbought stock, and a reading below 30 indicates an oversold stock.

 

 

Moving Averages (MA)

 

Traders use moving averages to find evolving market trends and determine whether a market is rangebound.

 

 

 

The Simple Moving Average

 

(SMA) is a popular technical indicator to identify trends within price charts for short-term and long-term trading strategies. It shows the average security price over a certain period.

 

Moving averages are a lagging indicator that helps identify entry points for a momentum trader. You can use it with other technical indicators for your momentum trading strategy.

 

 

Average Directional Index (ADX)

 

The ADX indicator measures when a trend gains or loses momentum.

 

It considers the moving average of price action over the period and is shown as a single line on the graph. A value of 25 or over indicates a strong trend, while a value below 25 indicates a weak trend.

 

 

Moving Average Convergence Divergence (MACD)

 

Traders use this technical indicator for future predictions. It helps them decipher whether new trends are bearish or bullish. The trend oscillator uses price data and plots it on a graph as a time series.

 

If the MACD unites with price action, it confirms the strength and an upward trend. At the same time, the divergence of MACD with price action validates the weakening and turn-around of a downward trend.

 

 

The Stochastic Oscillator

 

This leading indicator compares the most recent stock closing price to the previous trading range over a specified timeframe. It follows the momentum and speed of the underlying market to foresee price movements.

 

 

 

15. Frequently Asked Questions FAQs

 

 

Who Is a Famous Momentum Investor?

 

Richard Driehaus has been regarded as the father of momentum investing.

 

 

What Are The Dangers of Momentum Investing?

 

Buying high and selling higher is the objective of momentum traders. Still, this objective comes with its fair set of challenges.

 

Relying solely on recent purchases by other market participants when investing in a stock or ETF can be risky. The upward pressure on the asset's price is not guaranteed to persist, as external factors like news developments can alter market sentiment and trigger widespread selling.

 

Secondly, for investors who already hold a buy position in the stock or ETF, it is possible that selling existing positions for profit will overpower new market entrants, thereby forcing prices down.

 

 

Can You Make Money From Momentum Trading?

 

Yes and No. Often, stocks tend to move multiday upward after releasing solid earnings.

 

If it happens, there can be immense scope to make substantial money in such stocks.

 

However, there is also a risk that you may lose all of your money. Investing carries risk. Always do your research before making any moves.

 

 

Is Momentum Trading Risky?

 

Momentum trading, i.e., buying a rising stock and selling it at or near its peak, is much easier said than done. 

 

The trading style is based on identifying a momentum trend in an asset and expecting it to continue. However, there are no guarantees, as momentum can be transitory, and trend reversals can happen anytime.

 

The "timing" to enter and exit your position will determine your success and failure when trading assets based on momentum.

 

Furthermore, momentum stocks have twice the average beta of the rest of the market. This makes them highly volatile and prone to heavy price movements.

 

Traders who initially bought the stock as it was rising may swiftly reverse their positions due to various events, resulting in a sudden surge of selling. This, in turn, can induce panic among sellers, prompting them to exit their positions and driving the price lower.
 

In short, momentum trading is risky for making money in the stock market. It can be lucrative when things work out. Still, it can result in hefty losses if, due to external factors, things go against your analysis. So, trade wisely.

 

 

 

Is Momentum Trading Harder Than Day Trading?

 

Momentum trading is a subset of day trading.

 

The critical factor to succeed in the stock market is identifying stocks on the move.

 

This task is not particularly challenging, as nearly every day, some stocks experience significant price shifts, often in the range of 20 to 30% or even more.

 

 

Is a 70% Win Rate Good in Trading?

 

A win rate between 50% and 70% is considered good in trading.

 

 

Can You be Profitable With a 30% Win Rate?

 

Yes and No. Most profitable traders have win rates as low as 30%. It is about managing risks in your trades and taking advantage of each opportunity.

 

 

Is a 90% Win Rate Possible in Trading?

 

The percentage of successful trades doesn't matter much in stock market trading.

 

Even if a strategy wins 90% of the time, you can still lose money without proper risk management. On the other hand, a strategy with only a 20% win rate can sometimes make you rich.

 

A trader who doesn't use and stick to stop-loss orders will have difficulty making money. If you don't grasp the idea of stop-loss, you might make some money when you win but lose a lot more when you don't.

 

 

What Is a Healthy Win Rate?

 

The win rate represents the proportion of winning trades compared to the total number of trades placed.

 

Typically, proficient traders tend to achieve win rates ranging from 45% to 65%. A win rate exceeding 50% is generally regarded as a solid and healthy performance benchmark for traders.

 

 

 

What is The Win Rate for Professional Traders?

 

While a high win rate doesn't guarantee profitability, it can be a valuable metric for assessing a trader's consistency and performance.

 

Traders can attain a high win rate and maintain consistent success in their trading careers by employing a blend of strategies and risk management techniques while maintaining a positive outlook.

 

 

How Could You Increase Your Win Rate?

 

Increasing win rates is essential to achieving steady profitability in trading. Here are a few things that can help you get higher win rates:

 

• Traders must understand their trading style, goals, and the market conditions that align with the approach. Past performance of stocks and identification of patterns help traders hone their technique and increase their possibility of success. 

• Secondly, effective risk management, including stop-loss orders, position sizing, etc., can help traders limit their exposure to losses. Safeguarding your investment can help traders avoid significant losses and keep their win rates high.

• Finally, staying disciplined in their trading and clinging to their strategies can help traders lessen stress and enhance their confidence. A positive mindset will help improve their win rates and better decision-making and prevent them from making emotional decisions. 

 

So, what is the formula for the win rate? A positive mindset, focus on high-quality trades, and effective risk management can increase a trader's chances of success and attain their goals.

 

 

What is an Example of a Win Rate?

 

Winning and losing are part of trading. Traders shouldn't allow their emotions to impact their decision-making.

 

Traders can improve their strategies over time by keeping a trade log and regularly reviewing their win rates to identify areas for enhancement.
 

Win Rate	Number of Trades	Winning Trades	Losing Trades
50%	100	50	50
60%	100	60	40
70%	100	70	30

 

 

16. Conclusion

 

Momentum trading is not for everyone. When traded with discipline, it could lead to potential returns.

 

However, it carries inherent risks and can lead to losses if markets reverse suddenly. Thus, careful analysis, proper risk management, and a swift reaction to momentum trends are vital traits that can help you succeed in this strategy.

 

If you don't have a share trading account yet, consider eToro, used by many investors in Australia and worldwide. You can create an eToro trading account HERE.

 

eToro AUS Capital Ltd ACN 612 791 803 AFSL 491139. OTC Derivatives are speculative and leveraged. Not suitable for all investors. Capital at risk. See PDS and TMD

 

 

 

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