Momentum trading is a common strategy that relies on price movements for opening trading positions. The momentum measures strength and velocity of price movements compared to actual price levels, and is calculated by comparing price differences for a fixed period of time.
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 favorable 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. Unlike trend analysis, momentum trading is based on the movement momentum rather than the start and end points 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 Driehaus’s 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 survive 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.
What Determines Price Momentum?
Momentum of prices in the financial markets revolves around three main aspects; Volatility, Volume and Time frame. Volatility refers to the price fluctuations of an asset. It is typically measured by the difference between the opening and closing prices over a certain interval of time. It can also be defined by how quickly prices fall or rise. While volume indicates how much the asset is being traded and is a main indicator of the asset’s liquidity.
Liquidity reflects how active the market is. It is how easily or quickly you can execute a trade. Typically, it is determined by the total active traders and total trading volumes.
Also, the time frame is another significant factor for momentum traders. Short-term is commonly used for momentum trading, though the duration can be subjected to how long a trend can keep its momentum.
All three factors are vital to momentum traders as they benefit from short-term price movements. The higher the liquidity, the quicker they can enter and exit the trades. Volatility and price fluctuations are favorable in momentum trading as well.
What is a momentum indicator? It is a technical indicator that measures the momentum of the price movement. The momentum indicator is a critical tool for forex technical analysis that 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 Indicators
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)
The moving average (MA) is a calculation to analyze data using 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.
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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