What is Momentum Trading?

What is Momentum Trading?

Momentum trading is an investment strategy that involves purchasing an asset that has experienced a notable price or volume movement. It follows the principle of "buy high, sell even higher."

Momentum trading is a strategy that describes supply and demand in financial markets, particularly in price fluctuations, and suggests that asset prices that have been rising steadily are likely to continue rising for more time, or vice versa for asset prices that are falling. This can be explained by the tendency of asset prices to rise or fall from their current values.​

Its framework is similar to that of a trend-trading system. Momentum traders use indicators to measure price movements and calculate trends. Some indicators measure the strength of the market, in which case traders would buy into markets that are rising and sell into markets that are falling.​

Other momentum indicators measure the momentum change, determining when to trade and in what direction to go. The goal for every trader using a momentum indicator is to spot turning points before other investors do. When price trades above a moving average, buys above an uptrend line, or breaks through resistance levels, this information tells traders that buying is the right way to play the trend and they should increase their positions.

​When price trades below a moving average, sells below an uptrend line, or breaks through support levels, this information tells traders that selling is the right way to play the trend and they should decrease their positions. When these signals start appearing, traders open new orders or modify existing ones to benefit from the anticipated profits. 

Momentum Trading-Ways to Trade on the momentum

Momentum trading meaning is based on the theory that solid stocks will continue to rise or fall in price, and weak stocks will continue to drop. So, momentum traders buy stores that are moving up at a price and sell short supplies that are dropping in price. There are two ways to trade momentum:

1. Short term momentum: This strategy looks for short-term price trends. It may be a few minutes, hours or days. This type of momentum trading can be used in any market environment and with any time frame chart. Short-term momentum traders are also called day traders, who close out all their trades at the end of the day.

2. Longer-term momentum: Longer-term momentum traders use daily charts, weekly charts and monthly charts to identify longer-term uptrends and downtrends in the market and individual securities. The advantage of using more extended time frames is that it filters out much of the noise and volatility of shorter time frames.

How does Momentum Trading work?

As per Momentum Trading, you should enter a stock when its price has just started moving up and exit as soon as it starts declining. The idea behind this strategy is that the costs of stores often don't reflect their actual value for an extended period, and they tend to move in one direction for long periods.
Momentum trading is a strategy that aims to capitalize on the continuance of existing trends in the market. Momentum traders usually buy or sell an asset moving intensely in one direction and exiting when this movement shows signs of reversing. They also seek to avoid buying or selling assets that are moving sideways.

Momentum trading requires identifying the prevailing trend and then picking stocks that have the most robust momentum within that trend.

For example, suppose you are bullish on the Indian stock market and would like to go long on stocks with solid momentum. You would first look at a chart of the Nifty index to identify the prevailing trend (upward) and then identify stocks with solid upward momentum within this broader bullish trend.

Momentum traders do not hold stocks for long periods; they enter and exit trades quickly, sometimes having stores for as short a day or even an hour or less, depending on their technical indicators.
 

Elements of Momentum trading

Momentum trading is recognizing and profiting on significant upward or negative movements in asset prices. Traders look out assets with substantial trading volumes, which frequently indicate the strength of the trend. Moving averages, RSI, and MACD are important technical indicators for gauging momentum and determining exact entry and exit locations. 

Timing is critical in momentum trading, as traders want to join as momentum increases and leave before the trend reverses. Effective risk management, such as placing stop-loss orders and regulating position sizes, is critical for protecting against unexpected market movements.

Momentum Trading Strategies

Here’s a brief overview of each momentum trading strategy:

Trend Following: This strategy involves identifying an existing trend and trading in its direction, assuming that it will continue. Traders use tools like moving averages to confirm the trend.

Breakout Trading: Traders look for assets breaking above resistance levels or below support levels. Entering a trade at the breakout point aims to capitalise on strong price movement.

Pullback Trading: This strategy focuses on entering a trade during a temporary price retracement within a trend, with the expectation that the trend will resume.

Relative Strength Strategy: Traders select assets showing strong performance relative to their peers, betting on their continued outperformance.

Moving Average Crossover Strategy: When a shorter moving average crosses above a longer one, it signals a buy; when it crosses below, it signals a sell.

Volume-based Momentum Strategy: Strong price movements coupled with high trading volumes often indicate the persistence of momentum, aiding entry and exit decisions.
 

Scenario of Momentum Trading

Positive Momentum: TCS (Tata Consultancy Services), a stock traded on the National Stock Exchange (NSE), sees a spike in price following the announcement of a lucrative multibillion-dollar international contract.  Both institutional and ordinary investors are quite interested in this news, which leads to higher trading volumes.  The price of the stock is still rising and is in a strong uptrend.  Technical indicators like the Relative Strength Index (RSI) or MACD are used by momentum traders to spot this trend early. They then open long positions and hold the stock until indicators of waning momentum, like falling volumes, appear.

Negative Momentum: Following the government's announcement of tighter limits on medicine pricing, the price of a stock listed on the Bombay Stock Exchange (BSE), such as a mid-cap business in the pharmaceutical sector, drops precipitously. Investor panic is sparked by this, which results in strong selling pressure and large volumes. By identifying the negative trend and taking short positions, traders using momentum methods profit as the price keeps down. They sell their bets before indications of stabilisation, such as decreased volatility or a reversal candlestick pattern, emerge.

Benefits of momentum trading

Momentum investing offers the potential for high profits over a short period by capitalizing on market volatility. Investors buy stocks that are trending upward and sell them before prices decline, aiming for substantial returns quickly. This strategy leverages the market’s volatility and the emotional decisions of other investors. 

By systematically identifying specific buying and selling points, momentum investors avoid emotional responses and instead profit from the market’s natural fluctuations. When executed correctly, this approach can yield significant returns, making it an attractive strategy for disciplined and risk-tolerant traders.

Drawbacks of momentum trading

Momentum investing, while offering potential high returns, comes with significant drawbacks. The strategy carries the risk of mistiming trades, which can lead to substantial losses. High stock turnover is another concern, as frequent trading can result in expensive fees, especially for beginners. Additionally, momentum investing is time-intensive, requiring constant market monitoring to make quick decisions. 

The strategy is also highly market-sensitive, performing best in a bull market where investor herding is common. In a bear market, opportunities diminish as increased caution among investors reduces profit margins.

Momentum Trading -The Process

To conduct momentum trading, you must first identify the asset trend you're analyzing. This can be done by placing support and resistance levels on your charting platform or using indicators such as moving averages or Fibonacci retracement levels.

If you have identified an upward trend, you will place your buy orders slightly above the current market price so that the asset has the opportunity to reach your entry point before it starts its move back down. Your sell order (or limit order) will be placed at a predetermined level above the current price so that when it is triggered, you exit your position with a profit.

The opposite is true for downward trends: You enter your trade slightly below the current market price and place your sell order (or limit order) below it so that it is triggered when the price starts to make its way back.

The basic idea behind momentum trading is the 'momentum effect'. The momentum effect is based on the principle that high returns (or low returns) will be followed by other high returns (low returns). Thus, a stock's momentum is a measure of its rate of acceleration in price. A stock's fee may be rising more quickly than usual if it has positive momentum, while it may fall faster than normal if it has negative momentum.

Conclusion

Momentum traders believe that prices that have been moving in one direction over some time will continue to move in that direction for a limited period. They believe that buying high price momentum stocks and selling low price momentum stocks will result in portfolio outperformance.