What Is Momentum Trading

Momentum Trading

Momentum Trading is an approach that involves buying and selling assets according to the current price trends.

The term “momentum” came from Newton’s first law of motion. Newton stated that when an object is in motion, it tends to stay in motion until an external force acts upon it.

Applying this law in currency markets, it expresses that when the market is in momentum, it stays that way instead of the reverse.

What is Momentum Trading?

Like any other trading strategy, the core concept of Momentum Trading is to buy assets that are rising and sell those who are declining. Traders work with volatility to find buying and selling opportunities in short-term trends.

Trend in momentum
Trend in momentum

Although the momentum was known before, Richard Driehaus turned it into a strategy. He gave the idea that traders can possibly improve performance by “buying high and selling higher.”

Richard suggested selling losing trades, and continue riding winning trades while re-investing the money from the losing trades in assets that are going up.

Sounds confusing?

The theory is, momentum traders identify the strength of a trend in a given direction, then take advantage of market volatility. They take short-positions for an asset going up and sell them as soon as it goes downwards. After that, traders move their attention to the next positions.

Momentum Trading is like riding a wave for a short period, then move to the next wave before the first wave goes down.

Momentum traders may take profits earlier by following a herd instinct. Herd instinct is a phenomenon in financial markets in which traders know what other traders are doing and follow the crowd. Knowing the forex market sentiment can be very beneficial.

Indicators for Momentum Trading

Due to the nature of trading, momentum traders depend on technical indicators for finding a momentum trading strategy. These indicators help to define the overall trend and provide traders with entry and exit signals.

Popular indicators for Momentum Trading are; momentum, relative strength index, stochastic.

1. Momentum

No surprises here. The Momentum indicator is one of the most popular indicator for Momentum Trading. It is an oscillator, which means it has levels. The range of the levels depends on the type of chart.

Momentum indicator on a chart
Momentum indicator on a chart

The chart above illustrates the momentum indicator values between 93.51 and 103.49. If the values are closer to 93.51, it’s a downtrend. And if the values are closer to 103.49, it’s an indication of an uptrend.

2. RSI

Relative Strength Index is another momentum-based indicator. It has levels from 0 to 100. The values below level 30 are oversold, while the values above level 70 are overbought.

Here’s what the indicator appears on a chart:

RSI on a chart
RSI on a chart

3. Stochastic

The stochastic is a popular technical indicator to help identify price movements. Like the RSI, it has levels between 0 to 100. If the values are above 80 level, it’s an overbought condition. And, if the values are below 20, it’s an oversold condition.

There are two lines; mainline and a signal line. If two lines cross each other, this signifies a change in the direction of the price.

Stochastics on a chart
Stochastics on a chart

Other than these three, traders also use moving averages for Momentum Trading.

Momentum Trading strategy

For Momentum Trading, traders consider three factors; volatility, timeframe, and volume.

  • Volatility is a change in an asset’s price. High volatility means the market is moving sideways, while low volatility means a stable market.
  • For Momentum Trading, traders may consider short-term market movements. So, scalpers and day-traders can take benefit from this.
  • Volume is the amount of an asset being traded in a timeframe. If the market has high volume, it’s a liquid market and vice versa. You can use a volumes indicator to check the current market volume.

Momentum traders combine these factors with other indicators and forms of marker analysis to create their own trading strategy according to their own trading style and goals.

Momentum Trading Example

Here’s an example of Momentum trading with stochastic indicator:

The chart below displays a sell strategy. The overall momentum is downwards, as stochastic is showing it. After the downward momentum, traders can enter at the bearish candle with the stop-loss place at the recent high. They can exit the trade when the stochastic shows an upward movement.

Momentum Trading sell setup
Momentum Trading sell setup

The chart below pictures a buying strategy. The momentum is upwards, so there is a buying opportunity. Traders can enter at the bullish candle, and set a stop-loss at the recent low. They can exit the trade when the stochastic presents a downward movement.

Momentum Trading buy setup
Momentum Trading buy setup

Momentum Trading conclusion

Momentum trading is a forex strategy in which traders look to buy currencies that are rising and sell them when they look to have peaked.
The goal is to work with volatility by finding buying opportunities in short-term uptrends and then sell when the currencies start to lose momentum.

Harmonic Patterns can be used on your trading platform charts to help filter potential trading signals as part of an overall trading strategy.

I would prefer to use a momentum trading strategy on the 1-hour charts and above. I tend to find that these charts contain less market noise than the lower time frames and thus give more reliable signals for my forex trading strategies. This also means that I spend less time staring at charts and can also set alert notifications to let me know when price has reached certain levels, candlestick pattern has been formed or a particular indicator value has been reached.

I would consider creating a momentum trading strategy using technical indicators such as moving averages, Parabolic SAR, Stochastic Oscillator, RSI, ADX and price action analysis.

Of course, every trading system will generate false signals which is why money management is so important. I would personally be implementing sensible money management and only take traders that give me a favorable risk to reward ratio, ideally of at least 1:3. This means that one losing trade does not wipe out consecutive winners.

The methods of implementing a momentum trading strategy that are outlined within this article are just ideas. I would always ensure that I have good money management, trading discipline and a trading plan when using any forex strategy.

Furthermore, I would combine multiple technical analysis, fundamental analysis, price action analysis and sentiment analysis to filter all entries. You should trade forex in a way that suits your own individual style, needs and goals.

If you would like to practice momentum trading, you can open an account with a forex broker and download a trading platform. If you are looking for a forex broker, you may wish to view my best forex brokers for some inspiration.

Happy trading!