What is Momentum Trading?
Momentum trading is the buying and selling of assets with respect to the prior strength of the trend.
The rationale behind it is that having a strong force behind it, the price is bound to keep moving in that same direction.
To be precise, if the price is rising and has been recently rising so furiously, then it will tend to continue rising.
On the other hand, if the price has been falling and behind it is a strong and furious fall, then such force will tend to keep driving the price lower.
Traders who position themselves correctly in the direction of the price momentum stand a chance to profit significantly.
When the price on an uptrend hits a new high, most buyers will tend to be attracted to buy, driving the price higher.
This continues until enough sellers have entered the market to cause a trend reversal.
On the contrary, most sellers will tend to be attracted to a downtrend market which hits a new low, driving the price lower.
This will continue until enough buyers enter the market to cause a price rise.
Now that you understand what momentum trading is, how about you now learn how to trade momentum?
Choose the Assets to Trade.
Choosing assets for momentum trading is not difficult.
You want to pick those assets which have a very high likelihood of having either an upward or downward price momentum so that you don’t have to wait all your life for price momentum to develop.
So how do you choose suitable assets for momentum trading?
You can use the 15-period Rate of Change (ROC) values of the prices of currencies.
Rank the currencies in terms of the values.
After doing so, pair the base currency of the pair with the highest and the base currency of the pair with the lowest value in that manner until you get the best currency pairs to trade.
Here are currency pairs ranked with respect to their values of the 15-period ROC:
- CHFUSD – (+4.02%)
- CADUSD – (+0.83%)
- EURUSD – (-1.33%)
- AUDUSD – (-3.21%)
If your pair the strongest against the weakest pairs, you will get AUDCHF, EURCAD, and so on if you had more currency pairs to rank.
You can then proceed to the next step after getting the currency pairs to trade.
If you want to buy stocks, pick those which are in an uptrend for long enough, considering the business intrinsics as well.
On the other hand, if looking for stocks to sell, choose those portraying a downtrend in the broader market view.
Futures and Other Assets:
If you don’t want to trade stocks or currencies, just look for futures or any other assets which are showing a furious rise of fall in the price.
The rationale is to buy as the price moves furiously up or sell when the price is furiously falling.
Establish Price Momentum.
Have you just chosen which asset to momentum trade?
Well, that brings you to this next step, where you will establish the price momentum of that currency pair, stock, or other assets you have chosen.
How do you established momentum?
There are a number of ways you can use for this step.
- Price Action – upward price momentum will be shown if the price keeps posting higher lows and highs. Downward price momentum on the flip side, is evident where the price keeps posting lower highs and lows. Beware of support and resistance levels or any other price reversal points as you resort to price momentum in a given direction.
- Volatility – high volatility means that the price is changing very fast and significantly. Low volatility, however, means that the price is changing slowly and insignificantly. High volatility is paramount for momentum trading because the market must change rapidly and markedly towards a particular direction in order to identify price momentum.
- Volume – the amount of the asset you have chosen which is being traded at any given time is key in determining momentum. Having a steady stream of buyers drives the price up hence an upward price momentum. On the other hand, having enough sellers drives the price down hence a downward price momentum.
- Indicators – The Momentum Indicator, Relative Strength Index, and Stochastic Oscillator are key indicators to establish price momentum. The indicators must-read on either side of the zero line or show a rise in momentum towards a particular direction in order to resort to price momentum in that direction.
Confirm Price Momentum.
Did you just establish price momentum in a particular direction?
Then it is time to pass that momentum through a test before entry.
What tests exist for price momentum?
Several, and here are the best:
- Consolidation before breakout – had the price consolidated so well before the breakout in the direction of the price momentum? Then that is one way to confirm that such price momentum will continue.
- Trend continuation candlestick patterns – upward price momentum can be confirmed by the occurrence of uptrend continuation candlestick patterns. These include the ascending triangle and the bull flag. Downward price momentum, on the other hand, can be confirmed by downtrend continuation patterns. For example, the descending triangle and the bear flag.
- 50-MA Price Bounce – if the price has been hitting the 50-period moving average without breaking it in the direction opposite that of the price momentum, then it is evidence of strong momentum.
Enter Buy or Sell Positions.
Enter buy or sell positions depending on the direction of price momentum.
Adjust Stop Loss and Take Profit.
A Trailing Stop Loss is the best in Momentum trading.
You can have an initial Stop Loss of not more than 1% of your trading account. Move it as the trend grows, either manually or automatically.
Your Take Profit must target at least twice what you risk with your Stop Loss. Target more depending on the trade-up and how far the trend is likely to grow.