What is momentum trading – a full guide for beginners

Advantages and Disadvantages of Momentum Trading

Momentum investing can bring you huge profits, but only if you know how and why.

Pros

Potential for high profits over a short period

Let’s assume that you bought a stock for $50, growing to $75. You then sell it at a 50 percent profit before the price adjusts. This translates to a 50 percent return within just a few weeks or months. The potential profit increase can be significantly high when using momentum investing.

Capitalizing on the market’s volatility

Momentum trading is all about leveraging volatile market trends to your advantage. A good momentum investor looks for stocks that are trending upwards, then buys and sells them before they start going back down.

Capitalizing on other investors’ emotional decisions

Momentum investing is based on chasing performance. However, to be successful, you need to do this in a systematic way that involves an entry and exit strategy. Emotional investors can cause stock prices to change by making impulsive decisions, and you can take advantage of these changes to make a profit.

Cons

High turnover

High turnovers sometimes come with significant fees. Low-cost brokers are gradually eliminating this problem, but it is still a major issue for many rookie traders.

Time intensive

As a momentum investor, you have to regularly keep track of market details (sometimes even hourly). You need to get in early and jump out fast, as you are dealing with volatile stocks. This means keeping yourself constantly updated on any developments that may spook investors.

Market sensitive

Investors tend to employ a herding mentality in a bull market, making it great for momentum investing. However, the margin for profit is significantly lower in a bear market as investors tend to be more cautious.

Momentum Trading Indicators and Tools

As mentioned earlier, momentum traders are not necessarily concerned about the fundamentals of an asset– like the economic circumstances surrounding it or its long-term growth projections. The only thing that matters the most is price action, which is why many traders often use technical analysis and indicators to figure out when to enter and exit a trade.

1. The momentum indicator

The momentum indicator takes the cake for the most popular momentum indicator. It compares the most recent closing price with the previous one to help determine the stability of a trend.

The indicator comes in the form of an oscillator displayed as one line moving to and from a centerline of zero (sometimes 100). You can determine the pace of a stock's price by checking the reading on the indicator line. Most momentum traders use this indicator to determine a price action, but some rely on it to enter and exit trades.

2. Relative strength index (RSI)

The relative strength index (RSI) is also an oscillator that moves from 0-100, providing buy and sell signals. Like other range-bound indicators, it offers oversold and overbought signals depending on its reading. Anything below 30 is oversold, while anything over 70 is overbought.

Remember that the RSI indicator indicates oversold and overbought signals don't automatically translate to a change in the trend. The signal line can remain in the same territory for a long time, and it is important to use other indicators along with the RSI.

3. Moving averages

Traders use moving averages (MAs) to spot emerging market trends. They utilize a formula that disregards random fluctuations to reveal a prevalent trend.

It is important to note that moving averages are a kind of lagging indicator – the signals appear after the price changes. Of course, while you wouldn’t typically jump on a trend at the beginning anyway, you will need to employ other momentum indicators to identify an ideal exit point.

4. Stochastic oscillator

This indicator compares the previous trading range to the most recent closing price over a certain period.

The stochastic oscillator follows the momentum and pace of the underlying market rather than volume or price. It is considered one of the best indicators, as you can use it to project price movements.

If the stochastic does not return below the under-20 territory during a pullback, it could mean that the trend will progress upward.

Best Momentum Trading Strategies

All experienced momentum traders anticipate and keenly analyze the NFP (non-farm payrolls) data released by the U.S. Bureau of Labor Statistics (BLS) every first Friday of the month. The NFP is important economic information that shows how many new jobs were added to the market the previous month. The report excludes non-profit organization employees, farm employees, government employees, and private household employees.

The NFP release impacts all asset classes, including currencies and stocks. What’s more, when the US dollar moves, it affects other international assets as the US has the largest and most important economy in the world. Changes in the traders' view can lead to market volatility, which means more trading prospects and better profit potential. From this end, you need to use effective NFP trading strategies that capitalize on the initial volatility to attain a decent profit margin.

1. Trade before the NFP report is released

This simple strategy aims to scalp for high volumes small profits by utilizing the breakout strategies. Non-farm payroll release is a spectacular source of volatility that results in massive price swings. Observing the price action can go a long way toward predicting the market trend.

Trade the fade

This trading strategy involves initiating trades against the direction of the initial reaction. Depending on the price target, entry price, and actual data release, traders can overreact; jump in or out of trades, and cause intense activity. You can assess your position after the market stabilizes and determine whether to take the profits or reduce the losses.

Swing trading strategy

NFP is great for exploiting long-term trends. The unemployment numbers often impact long-term trends, and non-farm payroll defines the direction of the price. Traders usually use this data to assess whether the current month will be bullish or bearish. You can then apply swing trading to look for trading opportunities that will give you short to medium-term gains.