Momentum trading is an investment strategy that involves buying securities that are demonstrating strong momentum in a particular direction. Traders who employ momentum strategies are typically analyzing technical indicators to identify assets that are trending upwards, and attempt to ride that trend higher. Some key terms related to momentum trading include:
Technical analysis refers to the process of analyzing historical price data to identify patterns and trends that can potentially recur in the future. Momentum traders heavily rely on technical indicators and patterns.
Price trends are the overall direction of movement for a security’s price over time. Momentum traders aim to identify assets with upward price trends that may have further room to run.
Investment strategy in the context of momentum trading refers to the specific set of entry and exit rules traders employ when identifying opportunities. The three strategies outlined in this post are examples of momentum trading strategies.
Day traders seek to profit from short-term price movements by opening and closing positions within the trading session. Many day traders employ momentum strategies, trying to catch intraday trends.
Now that we’ve defined some basics, let’s explore three specific momentum trading strategies that can be part of an overall momentum trading approach:
Strategy #1: Moving Average Crossover
One of the most popular momentum indicators used by traders is the moving average crossover. A moving average is a trend-following indicator that smooths out price data by creating a continuously updated average price. Traders will monitor two moving averages, a short-term average and a long-term average, to identify crossover signals.
A golden crossover occurs when the short-term average moves above the long-term average, indicating that upward momentum is strengthening. This is seen as a bullish signal by traders. Conversely, a death crossover is bearish, occurring when the short-term average crosses below the long-term average. Traders will look to enter long positions on golden crosses or short positions on death crosses.
The moving average crossover strategy works best in strongly trending markets. Daily or weekly charts on liquid stocks and indices generally provide the clearest signals. While simple, moving averages have withstood the test of time as a reliable indicator of momentum. However, their lagging nature means signals may occur late in a move. Traders need to balance fast entry with whipsaws against the trend.
Strategy #2: Divergence Trading
Another powerful momentum indicator analyzed by traders is divergence. This occurs when the price action of an asset diverges or differs from what its underlying technical indicator is signaling. For example, if price makes a higher high but an oscillator like RSI fails to surpass its previous peak, this is considered a bearish hidden divergence. Traders will watch for signs the indicator and price may converge again in the opposite direction.
Bullish and bearish divergences can provide early insight into momentum shifts. A bullish divergence forms when the asset price makes a lower low but the oscillator fails to reach a new low, potentially signaling buyers are stepping in to prevent further downside. Traders may look to enter long positions on confirmation of an upward price reversal in this scenario.
Conversely, during an uptrend if price makes a higher high but the oscillator does not, this bearish divergence warns that upside momentum could be weakening. Traders then watch for confirmation of a price top and potential short entry. Divergences work best when identified early in well-established trends, as opposed to sideways markets.
The potential to catch reversals early is a major advantage of divergence trading. However, divergences are also prone to producing whipsaw signals, so traders need to be disciplined looking for confirmation. Price action may not immediately converge as expected. Additional filters like waiting for the moving average to be breached can help avoid premature entries against the prevailing trend.
Strategy #3: Breakouts and Pullbacks
The final momentum strategy involves identifying breakouts of key technical levels, with entries taken during subsequent pullbacks within the trend. Traders closely watch areas of prior resistance or support, now turned support or resistance after a breakthrough.
On daily or hourly charts, a security’s price may break above a ceiling, signaling buyers have overwhelmed sellers at that supply zone. Traders then look for a small pullback or consolidation, often in the 3-5% range, as an opportune lower-risk entry point to ride the new trend higher.
Similarly, if there is a breakdown below a floor, traders watch for a bounce that holds as new support. Fading this bounce by shorting or selling longs represents an entry into the lower trend. Proper position sizing is important, as pullbacks against the trend carry risk of further weakness developing.
The benefits of this strategy include its trend-following nature capitalizing on established momentum. By entering on pullbacks, traders obtain more favorable risk-reward compared to chasing breakouts. However, discerning real breakouts from fakeouts during high volatility periods takes experience. Whipsaws are also possible if pullbacks retrace too deeply against the trend.
In summary, the moving average crossover, divergence trading, and breakout with pullback strategies outlined above represent three approaches momentum traders commonly use to identify opportunities. Of course, no single strategy works in every market condition – the skilled trader integrates multiple techniques and knows when each is most applicable based on prevailing trends and volatility.
It’s also important to always use strict risk management with any of the momentum trading strategies. This means setting appropriate stop losses to prevent large drawdowns if the trend fails to continue as anticipated. Traders should also be on the lookout for changing conditions, like slowing momentum, that may warrant exiting positions.
While the strategies covered in this post focus on technical analysis of price charts, fundamentals also play an important role. Traders following strong momentum need to ensure there are no negative underlying catalysts, like bearish earnings, that could abruptly halt or reverse the trend. Conducting thorough due diligence on each trade idea is crucial.
With practice, momentum traders can learn to spot opportunities across different timeframes using these strategies. But it’s always advisable for newcomers to paper trade at first to gain experience without risking real money. Demo trading helps confirm a given system and one’s ability to manage emotions like fear and greed during drawdowns.