All You Need to Know About Momentum Trading

In this article, we will discuss

To use price changes in the securities market to their advantage, traders can rely on different types of techniques and strategies. Some of them involve capitalising on current trends while others involve anticipating potential price changes or reversals. One such strategy is momentum trading.

In this article, we explore the meaning of momentum trading, how it works, the indicators you can use and the common momentum trading strategies for success.

What is Momentum in the Securities Market?

In the securities market, the term momentum refers to the tendency of an asset’s price to continue moving in the same direction for a given period. The nature of this movement could be bullish or bearish. The crucial aspect is that the current price movement continues strongly in the same direction.

The concept of momentum in securities is based on the idea that assets that performed well in the near past will continue to do so in the near future (and those that performed poorly will also continue to do so). You can use various indicators to measure the momentum in securities, such as moving averages and the Relative Strength Index (RSI).

What is Momentum Trading?

Momentum trading is a strategy that involves leveraging a security’s momentum to profit from strong upward or downward movements. In simpler terms, it involves riding the current trend. Most momentum trading strategies aim to capitalise on a short-term uptrend or downtrend. This means that in a momentum trading strategy, you buy bullish stocks or securities and sell those that are bearish.

How Does Momentum Trading Work?

The common advice dished out to traders is to buy low and sell high. While this is technically prudent, there is no precise way to accurately assess when a prevailing trend may reverse. So, momentum trading aims to take advantage of the prevailing trend — meaning that you buy high and sell even higher (or vice versa).

The rationale behind this is that when an asset’s price is rising, it appears more lucrative to traders and draws in more buyers in the market. This, in turn, causes the price to rise further and adds to the upward momentum. Typically, this uptrend continues till the selling pressure mounts enough to outdo the buying pressure. Until such time, you can use a momentum trading strategy to leverage the strong upward price movement.

To make the most of the current trend, you need to assess how strong it is. This is because weak trends may not be sustained in the market long enough for you to exit your position at a profitable level. However, if the prevailing trend has a strong momentum driving it, the time may be ideal to implement a momentum trading strategy.

The Key Elements of Momentum Trading

In a momentum trading strategy, you do not need to enter or exit the market at the start or the end of a trend. Instead, you need to leverage the main body of a strong price movement before it fizzles out. This brings us to the following key elements in momentum trading or investing:

  • Security Selection

To effectively trade the trend and make the most of a security’s momentum, you need to focus on certain key aspects when selecting an asset. To begin with, the security you wish to trade in should have displayed strong price movements recently. These securities may have the potential to sustain their current trajectory, so you can capitalise on the momentum.

Liquidity is also equally important in momentum trading strategies. Only highly traded stocks or securities with tight bid-ask spreads can be easy to buy and sell at short notice. So, if you want to leverage the existing momentum before it dies out, you need to select liquid stocks/securities.

  • Trading Volume

Trading volume is another crucial element in momentum trading strategies. It refers to the number of shares or contracts traded in a particular asset over a specified period. High trading volumes often accompany strong price movements. This is because of increased market interest in a stock or security — which signals the potential for sustained momentum.

This is why you need to pay close attention to the trading volume when selecting assets for momentum trading. A surge in trading volume, especially when aligned with a price increase, can signal the beginning of a new trend. Higher trading volumes also suggest that more market participants are actively buying (or selling) the asset, confirming the current trend’s strength.

  • Price Volatility

Price volatility, which refers to the degree of variation in an asset's price over time, is also a critical consideration in momentum trading. Assets with higher volatility tend to exhibit larger price swings. This presents more opportunities for profit. However, higher volatility also increases the risk of losses because prices can change rapidly and unpredictably.

The norm is to select assets with higher volatility for momentum trading strategies because they offer the potential for quick and substantial gains. However, it is essential to be aware of the volatility of the assets you are trading and to adjust your strategies accordingly. By understanding and managing volatility, you can capitalise on momentum opportunities easily.

  • Timing the Entry and Exit

You should aim to enter trades when the momentum is strong — ideally at the early stages of a trend — to maximise the profit potential. Similarly, exiting trades at the right time is also important because it helps you lock in profits before the momentum reverses. To time your entry, you can use technical analysis tools such as moving averages, trendlines and momentum indicators.

For exit timing, you can again rely on technical analysis to identify signs of weakening momentum — like divergences between the price and momentum indicators or the price reaching key resistance or support levels.

  • Risk Control

You can use various techniques to manage risk in momentum trading — like setting stop-loss orders, position sizing and diversification. Stop-loss orders help you automatically exit a trade if the price moves unfavorably beyond a specified level. This limits potential losses and protects profits.

Position sizing involves determining the maximum amount of money that you are ready to allocate to each trade depending on the level of risk and your overall risk tolerance. Diversification is another risk management strategy that helps you spread your investments or trades across different assets to reduce the impact of a single asset's adverse price movement.

Momentum Trading Indicators

You can use different indicators to gauge the strength and direction of price trends. This will help you make informed decisions about your momentum trading strategy. Some common momentum trading indicators include:

  • Moving Averages

Moving averages are used to smooth out price data and identify the direction of the trend. You can check if there are any short-term and long-term moving average crossovers, which could signal potential entry or exit points.

  • Relative Strength Index (RSI)

The RSI is a momentum oscillator that measures the speed and change of price movements. It ranges from 0 to 100 and is typically used to identify oversold or overbought phases in the market.

  • Moving Average Convergence Divergence (MACD)

The MACD, a trend-following momentum indicator, is pivotal to understanding how two moving averages of an asset's price relate to one another. You need to keep an eye out for crossovers between the signal line and the MACD line — which may offer potential buy or sell signals.

  • Stochastic Oscillator

The stochastic oscillator evaluates how a security's closing price compares to its price range over a given period. Then, based on the security's momentum, this momentum indicator generates buy or sell signals.

  • Momentum

The momentum indicator measures the rate of change in an asset's price over a specified period. Here, you need to look for divergences between the momentum indicator and price movement as potential reversal signals.

Momentum Trading Strategies

Momentum trading strategies involve buying or selling assets based on recent price trends. You can use these strategies when you want to trade in assets that have performed well in the past and may continue to do so in the near future. There are several momentum trading strategies, including:

  • Trend Following

This strategy involves buying assets that are showing a strong uptrend and selling assets that are currently strongly bearish. You can use moving averages or trendlines to identify the direction of the trend and enter trades accordingly.

  • Breakout Trading

Breakout trading involves entering a trade when the price of an asset breaks above or below a significant level of support or resistance. This is ideal if you believe that these breakout points can signal the start of a new trend and look to profit from the continuation of the trend.

  • Relative Strength

This strategy involves comparing the performance of different assets and buying the strongest performers while selling the weakest. You may use relative strength indicators or ratios to identify these assets.

  • Momentum Divergence

This strategy is about looking for divergences between the price of an asset and a momentum indicator, such as the RSI or MACD. It may be suitable when you believe that these divergences can signal a potential reversal in the trend.

  • News-Based Momentum

This strategy involves trading based on market news and events that can cause sudden price movements. Here, you aim to capitalise on these momentum-driven price changes by entering trades quickly.

Become a Smarter Trader with Samco Securities

To become a successful momentum trader, you need to have easy access to live market data. Samco Securities provides you with these details free of charge in the Samco trading app. In addition to this, you can also access various technical indicators that make momentum assessment more effective.

Samco Securities also offers a wide range of other tools and features to make trading easier and more effective for traders in different market segments. As a Samco customer, you can use the brokerage firm’s proprietary options strategy builder Options B.R.O free of cost. You can also leverage the Samco margin calculator, TradingView charts, trade APIs and more to become a smarter trader.

Disclaimer: INVESTMENT IN SECURITIES MARKET ARE SUBJECT TO MARKET RISKS, READ ALL THE RELATED DOCUMENTS CAREFULLY BEFORE INVESTING. The asset classes and securities quoted in the film are exemplary and are not recommendatory.
SAMCO Securities Limited (Formerly known as Samruddhi Stock Brokers Limited): BSE: 935 | NSE: 12135 | MSEI- 31600 | SEBI Reg. No.: INZ000002535 | AMFI Reg. No. 120121 | Depository Participant: CDSL: IN-DP-CDSL-443-2008
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