Momentum Trading Strategy: Meaning, How to Use, and Examples

Momentum trading is a strategy where traders react quickly to market news and information. With momentum trading, a trader would try and make money by trading a security along with a trend. For example, if a stock is increasing after the release of an exceptional earnings report, a momentum trader will try to buy shares as the stock’s price goes higher.

Or, if a stock experiences a dramatic climb, with or without good news, momentum traders might buy shares hoping that the price will continue moving up. In other words, skilled traders will try to react to short-term, news-driven sharp increases or declines in the price of an asset.

What is a momentum trading strategy?

A trader using a momentum trading strategy will buy a security that is rising and sell it when its price appears to have peaked. A momentum trader will explore opportunities in short-term uptrends and then sell when the securities begin to lose momentum.

Experienced traders know when to enter into a position, how long to hold it for, and when to exit. The secret is the timing as the risks with momentum trading lie in the fact that a trader may open a position too early, or close it too late, or miss out on key trends.

Richard Driehaus and Momentum Investing

Richard Driehaus is often credited as the father of momentum investing. He popularised the strategy which has arguably delivered multiple annual returns of 30% for his hedge fund, Driehaus Capital Management in the 12 years after he established it in the 1980s. The premise of his concept was that more money could be made by buying high and selling higher.

Many of the techniques he used became the foundation of what is now called momentum investing.

Principles of Momentum Strategy

Momentum traders follow the market and volatility and try to capture uptrends by taking short-term positions in stocks or other assets that are going up and sell them as soon as they start to go down. The trader then moves to new positions and always tries to be the first to detect new opportunities and capitalize on them.

Risk management

Traders who seek to explore momentum markets need to have complex risk management rules to respond to volatility and unpredictable market moves that may eat through their funds. While traders need to act fast and catch a trend before it solidifies, they also need to be cautious and avoid traps by being organised.

Here are a few rules or tips to help you when you’re trading with a momentum strategy:

• Choose liquid securities.
• Beware of such risks as opening a position too early or closing too late, missing trends, keeping a position overnight or failing to act quickly and close a bad position.
• The best rewards are those when catching an early trend and opening a position when the time is right, while the risks are high when the trend is old and this is when opening a trade should be avoided.
• You should manage your positions wisely as spreads can widen and eat through your funds. Choose a holding period and avoid long positions as risks can increase significantly. Also, ensure that you reduce your position when you hold positions in multiple sessions to allow for flexibility and to stop placement away from the current action.

Momentum trading is not for everyone

Momentum trading may be rewarding but it does not mean it is for everyone. You will need to be disciplined and decisive as momentum trading will require you to take action instantly and close a bad trade and open another one that shows potential.

Factors, such as commissions, have made this type of trading impractical for many traders, but this story is slowly changing as low-cost brokers take on a more influential role in the trading careers of short-term active traders. Buying high and selling higher is momentum traders’ enviable goal, but this goal does not come without its fair share of challenges.

What are the best momentum trading strategies?

Momentum strategies use various momentum depending on which asset class you are trading.

For example, when trading momentum on stocks you may use volume indicators. But momentum trading works best with forex due to the 24-hour nature of the FX market and the various trading robots which help create a momentum-based trend.

Popular Indicators for momentum trading

The most popular indicators to trade momentum are the Moving Average Convergence Divergence (MACD), the Relative Strength Index (RSI) and Average Directional Index (ADX). When using forex momentum trading strategies many traders will combine these two types of indicators. While many momentum trading strategies would use one indicator, most sophisticated momentum trading strategies use a combination of two or even more. For example, traders can identify the direction of momentum with the moving average and pinpoint turning points for possible entries with a momentum oscillator.

Types of momentum indicators with examples

There are various momentum indicators in technical analysis. The most popular can be categorised as below.

Closing price compared to the previous close

This type of indicator helps traders identify leading momentum trading signals. They discover whether the market is overbought or oversold at close and whether it can change direction. Examples of these indicators are the Relative Strength Index (RSI) and the Rate of Change (ROC).

Closing price compared to range

This momentum technical indicator compares current price direction to past behaviour over a period of time to reveal whether the market is stronger or weaker. Examples of such indicators are the Stochastic Momentum Index (SMI) and the Commodity Channel Index (CCI).

Closing price compared to moving average

These lagging indicators compare the current price to averages over a period of time that has passed so traders can identify whether the price moves faster or slower relative to its average behaviour in the past. The Moving Average Convergence Divergence (MACD) is an example of such an indicator.

Why start momentum trading with IronFX?

Trade with a leading company and explore momentum strategies with the best resources and most advanced trading platforms. IronFX is a great choice for beginners and more advanced traders as it provides the right tools and services tailored to a wide range of levels. It is also a reliable broker catering to the needs of traders from all parts of the world in a fair and transparent manner. Renowned for its global presence and commitment to excellence, IronFX offers more than 500 instruments across forex, commodities, indices, metals, futures and shares.

The broker’s focus on cutting-edge technology means that traders have access to the latest platforms, including access to the MetaTrader 4 platform, mobile and web trading apps and many more, ensuring a seamless trading experience. IronFX also places a strong emphasis on security, ensuring that traders’ data always remains private and secure. When it comes to costs, the broker offers some of the tightest spreads in the industry, allowing traders to minimise costs and trade more efficiently.

The forex broker stands out for its flexible leverage and fast execution, so all trades are executed effectively and with very competitive trading conditions. IronFX’s customer support is also available 24/5, providing friendly and useful assistance to clients worldwide. Additionally, the broker offers educational resources and market analysis tools, empowering traders with valuable insights.

Disclaimer:
This information is not considered investment advice or an investment recommendation, but instead a marketing communication. IronFX is not responsible for any data or information provided by third parties referenced or hyperlinked in this communication.