What is Momentum Trading？
Momentum trading is a technique that involves buying or selling assets based on the strength of recent price trends. It allows traders to take advantage of market trends until it starts to wane. Strategies of momentum trading are more focused on price action than fundamental factors.
The stronger the momentum, the more likely the price will continue in the same direction.
Higher prices usually attract more investors, which pushes prices even higher. With increased momentum, the price will be heading in a bullish direction until sellers take over. This causes momentum to fade and so the price reverses its direction.
Momentum based trading is applicable on all financial markets, although it is most often applied on stock and forex markets due to high liquidity and favourable price volatility. Momentum traders focus on assessing the strength of the current price trend, take advantage of the trend by opening positions and close them when the trend begins to lose its strength. Unliketrend analysis, momentum trading is based on the movement momentum rather than the start and endpoints of the trend.
History of Momentum Trading
Richard Driehaus, an investing legend, is considered to be the father of momentum investing. His philosophy was based on the idea of buying high and selling higher. He believed in the strategy of selling the losers and letting the winners ride. His investing techniques shaped what is known as momentum trading.
According to Driehauss approach, investors should identify and buy stocks in a strong upward move and stay with the trend as long as it continues. He also believed that cutting losses short is very crucial to surviving in the market. The focus is on how much a trader makes out of his winning positions, and how quickly getting out of losing ones.
Momentum Indicators
What is a momentum indicator？It is a technical indicator that measures the momentum of the price movement. A momentum indicator is a critical tool for forextechnical analysisthat is focused on identifying whether the price is moving in a trend or not. Momentum based indicators can be utilized to generate trade signals, however, they are more helpful in confirming the strength of the price action as a confirmations tool.
Popular Momentum Indicator
1. Moving Average Convergence and Divergence (MACD)
The MACD is a momentum indicator that assesses market forces and indicates changes in momentum, direction and strength of a price trend. MACD is calculated by subtracting the long-term exponential moving average (EMA) from the short-term EMA. The indicator is bullish when the MACD line is heading up, and bearish when it falls lower below the zero level.
2. Moving Average (MA)
Themoving average(MA) isa calculation to analyze datausing the average change in a data series over time. MAs are commonly used to identify support and resistance levels as well as the overall trend. The moving average is not an official momentum indicator, but it helps in identifying entry and exit levels for momentum traders. The shorter the time frame, the more accurate the MA is, as in longer time frames the lags become greater. However, in shorter frames, the MA is more sensitive to price changes.
3. Stochastic
It is another popular momentum indicator that is created to show overbought and oversold zones. It is commonly used to identify possible profit-taking levels due to its ability to pinpoint where the price is expected to reverse. Also, it can measure price momentum by comparing trading range and closing price over a certain period. The Stochastic ranges from 0 to 100 levels. Below 20 represents an oversold market, and above 80 reflects an oversold market.
4. Relative Strength Indicator (RSI)
The RSI is one of the most common technical indicators. It is used to identify overbought and oversold conditions, price momentum and reversals. The relative strength indicator is shown as levels from 0 to 100. The RSI signals an overbought market by breaching 70, while lower than 30 indicates an oversold market.
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