Momentum trading is a technique for buying and selling of the stocks as per the recent trends of the price. In financial markets, the momentum is determined by factors like price change rate and trading volume. The traders move forward with a concept that the asset price moving towards the given direction will continue its movement until there is a loss of strength in the ongoing trend.
How did the concept begin?
Momentum trading has been into operation for centuries. David Ricardo was a well-known British economist and used to practice momentum trading in the late 1700s. The basic fundamental behind this trading is to reduce the losses and get the profits run on. There have been many notions used by the traders for momentum trading and the first notion was formally included in the trading education studies in 1937 by Herbert Jones and Alfred Cowles (renowned economists). It was believed that the assets performing well in one year used to work out well in their following year. This concept was being ignored from the 1930s onwards as the investors started focusing more on the fundamental value of the asset rather than the route of the price movement.
Relative Momentum: There is a comparative study made for the performance of different securities within a particular asset class and the investors give favor to buy the strong performing securities and sell-off the weaker securities.
Absolute Momentum: The behavior of the security price is compared against its former performance of the historical data.
In momentum trading, any of the strategies can be used. More frequently, the momentum trading strategies are mainly dealt with absolute momentum strategies. Momentum can be determined over longer periods or within the day-trading timeframe. The primary step is to determine the direction of the trend in which they want to trade. There might be an entry or selling point required to trade the stocks. There are stop-losses kept above or below the trade entry point to safeguard the investor for bearing undesired losses.
This is a common tool used to determine the momentum of a particular asset. These are graphical devices to show the oscillation in the price movement of a particular asset. This tool is meant to check the velocity of the price movements reaching towards a higher level when new money creeps into the way through new investors. The direction of the momentum can be calculated by Current Price – Previous price. The positive result denotes positive momentum and a negative result signifies the negative momentum. These tools appear as the ROC (Rate-of-Change) indicators which is equivalent to Earlier price/momentum result. The percentage of ROC can be calculated to plot high and low trends on the chart.
Common technical indicator tools
- Moving Averages: This value can help in identification of the overall price trends and the momentum by leveling the price movements into easily readable visual trends. It is calculated by adding the closing prices over a given number of periods and dividing the result by the total number of periods considered. This average can be simple or exponentially moving to give preference to the recent pricing action.
- Stochastics: This oscillating value makes a comparison of the current price of the asset with its range within a defined period. In the case of oversold conditions, the reading goes below 20 and it indicates the upward trending momentum. Similarly, when the overbought conditions are reached with a value of over 80, the downward momentum is expected.
- Relative Strength Index (RSI): It is measured by the strength of the present movement of prices over the recent periods. The major aim is to determine if the current trend is strong enough in comparison to its previous performance.
- On Balance Volume (OBV): This momentum indicator makes a comparison of trading volume to price. When there is a rise in the trading volume without a price change, it indicates the strong price momentum. Similarly, on the reduction of the volume, the signal is towards the diminishing momentum.
- Commodity Channel Index (CCI): This momentum indicator makes a comparison of the typical pricing of an asset against its simple moving average and the mean deviation value of the typical price. The aim behind these stocks is to check out the oversold or overbought options. The readings 100+ indicate the overbought conditions and the readings less than 100 indicate the oversold conditions.
- Moving Average Convergence Divergence (MACD): This tool indicates the comparison of slow or rapidly moving exponential moving price average trend lines on the chart against the single line. It depicts the possible price trend reversal and momentum points. Momentum is considered to be strong with the lines farther apart and slow with the converging lines.
- Average Directional Index (ADX): This tool aims at the determination of the trending momentum. The strength of the price trend is put over a graph having values of 0 to 100. ADX value below 30 indicates sideways price action or undefined trend and the values over 30 indicate the solid trend in any particular direction.
- Stochastic Momentum Index (SMI): This tool measures the midpoint of the recent high-low range by providing a notion of the price change in relation to the price range. This gives an idea of the nearby reversal point of the continuation of the current trend.\
- Building Block: This technique makes the traders divide the existing chart into equal periods (block separation). The blocks are coded in different colors for an upward or downward trend and the third color is used for a sideways trend.
Risks associated with Momentum Trading
Every style of trading is subjected to risks. When the prices follow on a trend, it is estimated to be successful. Traders need to remember that the technical analysis is based on the projections of the probability of the movements of price on the basis of the historical data. The market prices can move in any direction at any time due to any unexpected events, news or market sentiments.
Momentum is the major concept which has proved to be valuable for determining the profitable trading options. Its measurements can be used for short to long term based on different trading strategies. There are many technical tools available for revealing the strength of trends and checking if the trade on a particular asset is worth or not. Traders should be aware of the fact that the momentum projections are calculated on the basis of the previous price trends and actual momentum can change at any moment based on the unforeseen events.