Skill Sheet: What You Will Learn Here
- What is momentum trading in technical analysis?
- Advantages of momentum trading
- Tools to identify momentum
- Risk of momentum trading
Momentum, as we all know, is the state of motion, and a body in motion continues to be in motion (in a controlled environment) unless an external force is applied to it to bring it to a stop.
But what is momentum trading in technical analysis? Momentum trading by definition is based on the principle that a share in an uptrend will continue to remain in an uptrend unless the external factors that initiated that uptrend change. The same principle applies to a downtrend. Thus, it is safe to say that if a price move has enough force behind it, the force will try to keep that move in the same direction unless a bigger, more substantial, opposing force comes into play to stop or reverse the trend.
So the question is, what gives rise to a trend based on which the momentum gets built up and is used by the traders to ride the wave? As the price of a security increases due to any reason, it gains the attention of a lot of other traders who suddenly become interested in this stock. They also buy this stock in the hope of riding the wave and making good money, which raises the price further to a higher level. Then other traders start looking at the valuations and fundamentals and find that the price has moved way beyond what the fundamentals depicted. They then start selling this stock which brings a stop to the uptrend and also initiates a trend reversal.
Thus, in this kind of trading strategy, the traders look to take advantage of the volatility in an underlying scrip for which they undertake short-term trades depending on the primary direction in which the stock is moving, i.e., the uptrend or downtrend. They exit their positions as soon as they see signs of the momentum weakening.
Momentum trading is driven by a herd mentality. Typically, momentum investors try to take the first mover advantage in both legs of the trade, i.e., entry and exit.
Factors affecting momentum trading
Momentum trading is driven by three main factors, which are constituted by volume, volatility and time.
Volatility, which signifies how frequently the price of an asset changes direction, is the primary requisite to enter any trade using this strategy. Higher volatility entails big swings in the price trend, while lower volatility symbolises stability in the market. In momentum trading, traders look out for stocks that are experiencing volatility so that they can ride the waves (up or down) to earn profits. Since volatility is the key here, it goes without saying that traders should cover their tracks with proper stop losses.
Volume plays a big role in carrying forward an underlying trend. If the volumes keep rising, there is all likelihood that the trend/momentum will continue forward, while any decline in volumes can be an indicator of the trend coming to an end or maybe even changing its direction.
Please note that volume here does not pertain to the number of transactions, but it is more to do with the number of securities/assets being traded in all the transactions. Traders use momentum trading when the market/stock is liquid and the proportion of buyers and sellers is high. Illiquid stocks fail to generate investor interest, and their volumes are very low.
Trades based on this strategy are usually short-term trades depending on the strength of the momentum envisaged by the trader. Momentum trading is used by both position traders as well as day traders, also known as scalpers.
Tools to identify the momentum
There are various tools designed/identified by technical analysts that help execute the momentum trading strategy in a more effective manner. The following are the most commonly used tools.
As the name suggests, this applies a mathematical formula to arrive at the averages of the price data, which are then used to identify the underlying trend. The use of the formula removes the price fluctuations and helps traders identify if the market is trending or range-bound.
It is important to note that the moving averages provide the signal after the price move, and thus they have an inherent lag. This makes it important for traders using momentum trading to refer to other indicators to initiate or exit the trade.
A momentum indicator is a widely-used signal or tool that compares two adjacent closing prices to identify a trend. This indicator is like an oscillator and gives signals in the form of single lines and degrees for each price movement from the centre line. A positive degree indicates an uptrend, while a negative degree shows a downward movement.
RSI (Relative strength index):
This is a very effective tool for momentum trading as it not only indicates when the scrip is in overbought or oversold territory, but also when it has good momentum. Based on this, the momentum traders can get an idea of the entry and exit points of a trade.
The RSI is range-bound between 0 and 100. An RSI above 70 signifies an overbought situation and anything below 30 is an indicator of an oversold position. An RSI of 50+ indicates a strong positive momentum in the stock price. Therefore it is advisable to open or close a position between the 30 to 70 levels rather than at the top or bottom. However, it may be noted that a trend reversal may not always take place based on the price movement between this range, and it is important to have a backup strategy/tools along with RSI to confirm the hypothesis.
Like the momentum indicator, the stochastic oscillator compares the previous trading range, spread over a time period, with the most recent closing price. It makes use of the momentum of the underlying market and does not follow just the price or volume.
Momentum trading benefits
Here are some advantages of momentum trading. If executed with discipline, momentum trading can help rake in good profits in a short span of time. The strategy has the potential to generate high profits if the trader sticks to it diligently over a period of time.
Volatility is a constant in equity markets. There will always be some stock or the other that will be going through a volatile phase every day, and momentum trading can help traders to capitalise on the opportunities provided by these volatile conditions to make profits. They enter the stocks as they are rising and come out of them when the slide begins. The key here is to be the first mover so as to extract the maximum profits.
A lot of traders are unable to overcome their emotions while trading and tend to stick to their favourite stocks much longer than warranted. This leads them to commit mistakes, which the momentum traders feed upon. They aim to take maximum advantage of the price movements caused by these investors who are unable to leave their emotions behind.
Limitations of momentum trading
Nothing is perfect in this world. So there are also some risks of momentum trading that traders must be aware of.
Timing the trade assumes utmost importance in momentum trading, and this is where the major risk of momentum trading lies because it is always very difficult to time the markets. A right move at the wrong time can also result in huge setbacks.
This also makes the strategy time-consuming. A trader has to be updated with events all the time and monitor the stocks' reactions during their journey. Any negative news can jeopardize a solid trade easily.
Trades are short-term in this case, with too many instances of entries and exits. The high number of trades involves a higher amount of fees which can drain a trader's pockets.
The momentum trading strategy works like a charm in a trending market and more so when the market is witnessing a bull run. This is when the herd mentality of investors comes into play, paving the path for strategy experts to earn profits.
If traders can imbibe strict discipline in their trading styles, the momentum trading strategy can work really well for them.
Points to remember:
- Momentum trading is a strategy which aims to capitalize on the short-term price trend of the underlying security.
- Volatility and volume are two critical factors of momentum trading.
- Traders can make use of moving averages and momentum indicators like RSI for this strategy.
- Trade timing and overall market trend are crucial for momentum trading.