What is Momentum Trading?

Momentum trading entails buying assets or other financial instruments that have a sharp price or volume change. It operates on the belief that strong stocks will sustain an upward trajectory, and weak stocks may continue to decline further. Therefore, momentum traders buy stocks that are rising in price and short-sell stocks that are declining in price. Traders employing this strategy study price graphs and apply the technical indicators to spot assets that exhibit either upward or downward price movements. This blog helps you understand the concept of “what is momentum trading” by understanding aspects, momentum trading meaning, how it works, its benefits, limitations, and more.

How Does Momentum Trading Work?

The momentum trading approach assumes that strong price movements in a particular direction allow traders to profit from ongoing trends. Here’s how the momentum trading strategy works. 

• Momentum trading focuses on buying assets with upward price momentum and selling those with downward momentum.
• Traders analyze price movements, trading volumes, and other technical indicators to identify momentum.
• Traders have to monitor the breakout in trading, which can signal the start of new trends. Breakout meaning in trading is the movement of price beyond a specific support or resistance level. 
• Time frames for momentum trading can vary from short-term (days or weeks) to longer periods (months).
• Momentum traders often set predetermined exit points to manage risk and lock in profits. 
• Common tools used in this strategy include moving averages, relative strength index (RSI), and trend lines.

Momentum Trading: The Process

The following breakdown explains the process of momentum trading in step-by-step form:

Step 1: Identify the Prevailing Market Trend

• Conduct a thorough analysis of the asset's price movement by plotting support and resistance levels on your chart. 
• Enhance your analysis by incorporating advanced technical indicators such as moving averages or Fibonacci retracement levels, which can provide valuable insights into the asset's behavior.
• After careful consideration of these factors, make a definitive determination about whether the asset is currently in an upward or downward trend.

Step 2: Establish Your Trading Position

• When you've identified an upward trend, place your buy orders at a level slightly above the current market price. 
• This calculated approach allows the asset's price to reach your desired entry point before any potential reversal occurs. 
• Simultaneously, set a sell order (also known as a limit order) at a predetermined level above your entry price.

Step 3: Adjust Your Trading Practice

• In the case of an identified downward trend, position your entry point slightly below the current market price. 
• This tactical placement provides the asset with sufficient room to continue its decline before a potential upward bounce occurs. 
• Establish a sell order (limit order) at a carefully chosen level below your entry price, limiting potential losses or locking in profits.

Step 4: Monitor and Execute your Exit Strategy 

• Maintain a constant watch on your chosen asset, paying close attention to the predetermined price levels you've established. 
• When your sell order is triggered, promptly exit the trade to secure your profit in a successful scenario. 
• This disciplined approach to trade management is crucial for maintaining consistent performance in momentum trading.

Step 5: Conduct a Post-trade Analysis 

• After completing each trade, perform a comprehensive review of its performance and analyse the factors that contributed to its success or failure. 
• Identify specific areas within your strategy that may benefit from refinement or improvement. Apply the insights from this analysis to your future trades.

Example of Momentum Trading

Let’s understand the concept of momentum trading more clearly with an example. Suppose an investor invested in shares of company A and company B.  

Company A’s stock has an upward trajectory, which is an indication of positive momentum. The trader will buy the shares, expecting that the price will continue to rise. Conversely,  company B’s stock price is going downward, indicating negative momentum. The trader may short the B’s shares, expecting the trend to continue downwards.

In the case of company A, a trader purchases shares anticipating future price appreciation to sell them at an appropriate time for potential gains. In the case of company B, the trader thinks it is appropriate to short-sell the share. This entails borrowing shares and selling them, then again buying them back later at a lower price.

Types of Momentum Trading Strategies

The following is the breakdown of several types of momentum trading strategies: 

• Scalping: Scalping is a potentially fast trading method that makes small profits from small price changes. Traders need to make many trades each day, along with being quick and precise to succeed in this strategy.
• Trend Following: This strategy encompasses purchasing shares whose prices are on the rise and selling them off once they begin to fall. Selling and buying shares should be aligned with specific and accurate periods.  
• Gap Trading: Gap trading focuses on price differences between trading or gaps that show strong market reactions to the news. Traders can use them to get quick profits from price changes. This method needs a clear understanding of market sentiments and the reason causes price gaps.
• Reversal Trading:  The term “reversal trading” explains the fundamental concept behind this style of investing. When the price of a security declines, reversal traders buy stocks in the hope that the price of these stocks will increase again. If there are any signs of a price reversal, the traders should take a position against the trend but should also be aware of the risks.
• Market Making: Market making involves buying and selling stocks to keep the market active.  Momentum traders can use this to understand short-term price changes. It requires advanced trading tools and a deep knowledge of how markets work.
• Range Trading: In range trading, you must buy a stock at its lowest point, hold it till the price rises, and sell within those price limits. This can be an appropriate strategy in markets with low or non-existent price movements.  

Ways to Trade On The Momentum

The basic principle of momentum trading is the belief that strong stocks are likely to rise in terms of price while weak stocks are likely to decline in terms of price. There are two primary ways in which momentum trading can be done.

Short-term Momentum

The short-term momentum trading is flexible and can be used in any market condition with different time frame charts. This approach concentrates on defining and considering various trends that last usually for short periods, ranging from a few minutes to a couple of days. Intraday traders usually use this strategy in day/intraday trading and usually carry out all their transactions to eliminate the chances of incurring losses on the next business day.

Longer-term Momentum

Traders who have been in the market for a longer time use daily charts and sometimes weekly charts and monthly charts to analyze the longer-term trends in the market or single stocks. The benefit of longer-term momentum is that it is effective for longer time frames. This further makes it easier to spot broad patterns without being distracted by the fluctuations in short time frames.

Benefits and Drawbacks of Momentum Trading

Momentum trading, like other strategies, carries several benefits and drawbacks. This is explained in the following breakdown.

Conclusion
Momentum trading can be a helpful approach to capitalizing funds in the stock market. However, it is not suitable for everyone's trading style. It entails monitoring the changing prices and making wise and quick decisions. Traders must remain focused and be prepared to execute trades within a short time. Learning how to use moving averages and RSI works effectively in identifying trends. A reliable share market app that enables the users to monitor the prices can be useful. However, be careful with your trading decisions and invest as per your risk tolerance level.