Momentum trading is one of the easiest and least time-consuming ways for traders to generate profits in the stock market. It has also turned out to be one of the most successful trading strategies over the last 20 years. Momentum trading can be done on any timeframe, using just a few technical indicators.
Momentum trading can be used to trade almost any asset. However, it is best used with stocks, ETFs, indices and commodities. A momentum trading strategy can be used to profit from rising or falling prices. Though, over the medium to long term, momentum traders usually focus on the long side.
- What is momentum trading?
- Momentum trading vs. momentum investing
- Why does momentum investing and trading work?
- What markets can be used for momentum trading?
- What type of setup should you look for?
- Which technical indicators are used for momentum trading?
- How to exit a momentum trade
- Elements of a perfect momentum trade
- Benefits and drawbacks of momentum investing
What is momentum trading?
Momentum traders enter positions in the direction of a trend. Then they hold those positions until the price momentum begins to slow, or until a profit objective is achieved. The term momentum, quite simply refers to the speed at which a price moves in one direction, and is usually compared to recent momentum.
The rationale behind momentum trading is that once an asset price begins to move in a particular direction, it is more likely than not to continue in that direction for the foreseeable future. Momentum traders generally don’t try to catch the top or the bottom of a trend. They rather try to capture the middle section of a trend when momentum first accelerates and then slows. While momentum trading is a type of trend trading, it is not quite the same as trend following. Trend followers use support, resistance, moving averages and recent highs and lows to define the trend, and then stay with that trend until they believe the evidence suggests it has ended.
Short term momentum traders use price patterns and technical indicators to open positions when they believe momentum is accelerating, and then enter a trade. They will exit the trade when momentum slows, a profit objective is reached, a stop loss is breached, or if the price encounters support or resistance. Long term momentum traders usually use relative momentum to pick the stocks with the greatest momentum. They will often rotate from one asset to the next at specific intervals, or when another stock shows higher relative momentum.
Momentum trading vs. momentum investing
The term momentum trading is used quite loosely to reflect a couple of slightly different approaches. All these approaches use price momentum in some way. Momentum investing is a term that is also used quite loosely. Momentum investing is sometimes used to refer to long term momentum trading based on price action alone, and sometimes to refer to investing based on earnings momentum.
Often when a company’s earnings growth begins to accelerate, it will continue to accelerate for then next few quarters or years. Momentum investors bet on the tendency of accelerating earnings growth to lead to stock prices outperforming. Of course, momentum investing can also refer to an investor using a combination of earnings growth and price action. You refer to momentum whenever a trading strategy involves the intensity of a price movement.
How does momentum investing differ from other forms of long-term investing?
Other forms of long term investing usually take valuations, fundamentals and economic factors into account. Momentum investing is based on the fact that earnings growth leads to stock price growth AND price momentum leads to more investors noticing and buying a stock. Momentum investors make use of technical analysis, unlike most other investors who rather focus on fundamental data and economic factors.
Why does momentum investing and trading work?
The tendency of rising prices to continue rising, and falling prices to continue falling is a well-known market anomaly which is not properly understood or explained in financial theory. Because it can’t be explained by theory, momentum investing was shunned by most investors for a long time.
The most probable explanation for momentum investing working, is that higher prices attract new investors. If an asset price performs well, investors who may have otherwise ignored the asset will take notice and may invest. If they invest, the price rises further, and more investors take notice. This feedback loop continues until large sellers enter the market or when some external event causes investors to re-evaluate the investment.
Over shorter periods, the success of momentum may be attributed to FOMO, or the fear of missing out. As a price begins to move either higher or lower, traders on the sidelines are forced to act for fear of missing out. This creates another feedback loop, with more traders jumping in the further the price moves. However, regardless of whether it can be explained or not, momentum investing has been proven to work. It is now widely used by quantitative investors who build models combining momentum factors with other factors like value, volatility and cash flow.
What markets can be used for momentum trading?
Almost any market can be traded using momentum trading strategies. However, markets with strong trends are best. Momentum strategies work best when prices move far enough in one direction for traders to capture profits. The following are the types of markets that are ideal for momentum strategies:
- Growth stocks, especially tech and consumer stocks, which have the potential to rise or fall by over 50% a year. Stocks with high growth rates and large trading volumes are known as momentum stocks.
- Cyclical assets, like cyclical stocks and commodities, provided the potential trading range is wide enough.
- Heavily traded indices, like the S&P 500 and Nasdaq. Whether you are trading futures, ETFs or CFDs, the major equity indices can offer great momentum trading opportunities on a lower time frame. This makes these markets and asset classes a perfect trading opportunity for day traders.
The following daily chart for Tesla is an example of the type of market and price action momentum traders should avoid. The probability of a momentum trade in a rangebound or congested market working out is very low.
What type of setup should you look for?
While there are lots of chart patterns that can set up a momentum trade, the following are three of the most straightforward patterns to look for:
- Trend continuation: When a stock consolidates within a trend, you can look out for the trend to continue. Don’t pre-empt this, but wait for confirmation that the trend has actually resumed.
- Change of trend: If a stock has been in an extended bull or bear trend, and then breaks the trend, you can look for a retracement, and then confirmation of the new trend.
- Breakout: If a stock has tested a support or resistance level several times and then finally breaks out, a momentum trade may be setting up. Look for a retracement and then look for confirmation that the new trend is underway. If you see confirmation, it would make sense to enter a momentum trade.
The chart above (GM daily, 2012) shows examples of all three types of setups, both on the long and short side. All of these situations start with the possibility of a new move starting, an initial move followed by a pause or retracement, and then confirmation that the next move is underway. This sequence of events will attract the maximum number of buyers or sellers. It offers the highest probability of the next move being large enough to profit from. This in turn creates great risk reward ratios for momentum trades.
Which technical indicators are used for momentum trading?
There are now hundreds of technical indicators available to traders. Almost all of them can be used as part of a momentum trading strategy. However, there is no need to complicate matters. You usually only need two to four indicators to create an effective trading strategy, and you only need the most commonly used indicators.
Perhaps the most useful indicator for momentum traders is a moving average. Moving averages can be used in several ways, and more than one moving average can be used on a chart. The chart below is a weekly chart of Amazon from mid-2017 until mid-2018. Included are 15, 25 and 35 exponential weekly moving averages. Some traders prefer to use 10, 20 and 50 period moving averages. The exact parameters are not important, but somewhere between 10 and 50 is best for momentum traders.
After a period of consolidation, Amazon’s share price resumed its upward trend in October. For an effective long momentum trade, the moving averages should be stacked on top of one another with the short-term average on top, and the long-term average at the bottom. They should also be diverging and creating a “megaphone shape”. This tells us prices are not rangebound and the trend is accelerating.
Momentum indicator and RSI
The momentum indicator and the RSI (relative strength indicator) are calculated using different formulas. However, the resulting chart is fairly similar. They should not be used on their own, but as confirmation that a trend is strong enough to enter. For long trades the momentum indicator should be above zero and the RSI above 50. For short trades the opposite applies. In the weekly chart for Facebook above, you will notice that both indicators crossed above the midpoint just before momentum accelerated.
In most cases, a momentum move that continues for some time will be accompanied by rising volume when the move begins. More volume, means more traders are coming into the market, and the price movement should continue. In the Facebook chart from the previous section rising volume accompanied the initial move after the indicators cross above the midpoint.
The stochastic indicator is usually used as an indication that an asset price has reached an overbought or oversold level. Indeed, momentum traders can use it this way too – as long as they are trading in the direction of the trend.
However, for momentum traders there’s another way to use stochastic indicators too. If a stock is in an uptrend, and the stochastic indicator becomes overbought, and then fails to retrace to the midpoint, this is a sign that there is a good chance the trend will continue. The stochastic indicator will often bounce around 80, as it does in the chart above. The opposite applies when pries are falling, and the stochastic indicators are in oversold territory.
Candlesticks and bars
Once you have identified a potential momentum trade, one of the easiest ways to choose your entry point is to look for a large bar or candle in the direction of the trend. If you are looking to enter a long trade and you are using a candlestick chart, wait for a green bar that is at least twice the height of the average bar. For short trades you are looking for a long red candle. Candles that are far bigger than average indicate buying or selling is becoming aggressive, and there is a good chance of trend continuation.
How to exit a momentum trade
With momentum trades you are not trying to catch the beginning of the move and you are not trying to catch the entire move. You are trying to reliably catch enough of the move to make a profit. There are several exit strategies you can use to make sure you lock in a profit before the price retraces.
- Trailing stop: Using a trailing stop allows you to protect your profits, while also capturing as much of the move as possible. This is a great exit strategy for long term trades when trends can last for months or even years.
- Predefined target: Momentum traders often exit their trades when the price reaches a target level. This can be a support or resistance level, or a level that gives a profit of three times the risk taken on the trade. It works well for day trading when the moves are smaller and it’s important to capture as much of the potential move as possible.
- Scale out: You can divide your position into two or three parts and exit each at a different target. You could exit a third at 2X the risk, a third at 3X the risk and then use a trailing stop on the balance to capture as much of the move as possible. This allows you to scale out your trade and reduce risk while still participating from the move.
- Stop loss: Not all momentum trades work out as planned. If the market doesn’t move as expected, you need to get out quickly and move on to the next trade. It’s best to keep things simple, and place a stop loss order just below the recent low for long trades, or just above the recent high for short trades.
How to incorporate relative momentum with your strategy
A great long-term strategy is dual momentum investing. This involves looking at the momentum of a particular stock, as well as the relative momentum of that stock against a sector index or market index. This allows investors to stick with the best trading ideas by focussing on the strongest stocks in the market. Dual momentum needs some time to work and is therefore not suitable for short term momentum trading.
Elements of a perfect momentum trade
The best way to trade using momentum is to create your own stock trading strategies by combining the ideas mentioned above with some of your own ideas. When you create your own trading strategy, you will understand it and you’ll have more confidence in it. You can also backtest your own trading strategy to see if it’s profitable.
Firstly, you must make sure the market is not rangebound or congested – prices should be moving decisively in one direction or another. There should be no major support or resistance levels close to the current price. Whatever indicators or process you use, before entering a trade you should be able to answer yes to all of the following questions. If the answer to all these question is yes, the trade has a high probability of working out.
- Could a decent move start here?
- Has it started?
- Is the price accelerating?
- Is volume confirming the move?
You also need to work out where your stop loss is going to be placed, and work out the risk reward ratio, based on a reasonable profit target. If your stop loss is $2 below your entry point, the target should be at least $6, or 3 times, higher. If there is strong resistance $3 or $4 higher, the probability of reaching your target is low, and the risk reward is low. You are looking for a risk reward ratio of at least 1 to 3.
Finally, you need a strategy to take profits. If your time horizon is long, you need a strategy like a trailing stop that will keep you in the trade for as long as the trend persists. For medium term trading, specific targets based on support or resistance levels work well. For day trading scaling out often is the best exit strategy.
Benefits and drawbacks of momentum investing
Momentum trading is a straightforward way to profit from trends without overcomplicating things. It’s also one of the best day trading techniques, provided market conditions are right. Whatever your schedule is like, you can create a momentum trading process that will work out with it. Some momentum investors use dual momentum strategies which they rebalance once a month, once a quarter or even once a year.
However, there are a few risks and drawbacks to be aware about. For long term momentum investors, the end of a bull market can lead to large drawdowns as momentum stocks usually are the ones that fall the hardest when markets turn south. For this reason, you should never devote your entire portfolio to momentum based strategies, and you must employ and obey stop losses.
Periods of increased market volatility with little directional movement can also lead to periods when momentum strategies generate false signals. If you have more than 3 losing trades in a row, it’s best to wait for the market to break out of the trading range to establish a new trend. If you are using intraday trading strategies based on momentum, you need to make sure market conditions are right. There should be enough liquidity so that the bid offer spread is narrow. Intraday moves are limited in magnitude. You need to manage your costs well to be profitable.
Conclusion: Momentum strategies for traders and investors
By now you have probably realised there are several types of momentum trades and approaches to take. There is no precise way to trade using momentum, and it’s best to work out your own process anyway. You can use the ideas mentioned in this article to develop a few simple trading techniques, and then tweak your process over time. It’s worth the effort, as these strategies can be used on most markets, across multiple time frames, and hopefully they will continue to work in the years to come. What are your thoughts on momentum trading?