What is Momentum Trading?
Momentum is the strength of the energy that something has when it is moving in any direction. It is a value that reflects the power behind any movement. In Trading, Momentum is the speed at which the prices of the financial securities are moving in a particular direction with time.
The strength of the momentum of any financial instrument is directly proportional to the speed at which it is moving in an upward direction or a downward direction.
How Momentum Trading works
Currency Pairs, Commodities, Cryptocurrencies, Stocks, and other financial instruments move in trends. Momentum trading is a way of making profits by trading in securities that are already moving in a trend with strong momentum.
The concept revolves around buying high and selling higher contrary to the traditional trading concept of buying low and selling high. Investors and traders buy a security that has already reversed a trend direction in the hope that it will continue to move in the same trend in the future.
Momentum Trading can be done in a short-term time frame as well as in a long-term time frame. Momentum Trading Strategies can be deployed in day trading, swing trading, or position trading for higher returns.
Momentum Traders only invest in the securities that are moving with strong price action and stay away from range-bound or sideway sessions. Traders sell the securities as soon as the financial security has peaked and lost its momentum. By applying the indicators, traders try to sell the security as soon as the trend starts reversing.
Momentum Trading in Forex
Forex Traders generally use Technical Analysis based on the Price Action of the Currency Pairs instead of using Momentum and volume-based indicators. In Forex, Price Action can easily deceive traders into wrong trade entries and exits. Whereas Momentum is a more reliable indicator in the trading of Currency Pairs as compared to Price Action.
Some Currency Pairs are highly volatile, the prices can touch up and down extremes in little time. Fear and Greed can easily come into play and a Forex Trader can make a wrong decision. Currency Pairs can be more volatile compared to stocks or commodities in shorter time frames. On longer time frames the Forex Currency Pairs are relatively stable giving good investment and trading opportunities.
Analysis and Expertise for Momentum Trading
Technical Analysis is considered to be the backbone of Momentum Trading Strategies. Traders utilize technical analysis tools and indicators to analyze the charts of Currency Pairs to make trading decisions.
A trader interested in momentum trading should have basic knowledge of charts, price action, technical analysis, indicators, and indicator selection. A Combination of Technical Indicators is used by traders to develop a trading strategy based on momentum trading.
There can be some currency pairs that move in trends strongly. They stay in an uptrend for longer sessions or in downtrends. The range bound, choppy or sideways sessions in those currency pairs are not very often. A Currency Pair can build momentum on either side bearish or bullish. The momentum doesn’t need to be always on the bullish side.
On the other hand, some currency pairs have range bound or sideways trading setups on longer time frames and the prices are moving in a range of up and down. These range-bound currency pairs are not a good option for momentum trading. For the range-bound currency pairs, a Forex Trader has to devote more time to analyze the charts and wait for the momentum to build up.
The Momentum can be built in a currency pair due to many reasons, the force under the price movement can be due to fundamental changes in the currency or it can be based on emotions or it can be a technical setup.
A Forex Trader has to be very vigilant on the news and changes in the socio-economic conditions. Changes in the interest rate, Inflation, GDP forecasts, Trade Deficit, and other economic numbers can trigger the price movement strongly.
The Momentum Indicators
Traders and Investors apply different tools and indicators for Technical Analysis of Forex Currency Pairs and other securities. Momentum indicators are the indicators that are used to measure the rate of change of speed at which a security is moving in a particular direction.
Momentum Indicators are used to measure the strength of the price movement. Momentum Indicators can be used with other types of indicators to develop a trading strategy.
Forex Traders also apply the concept of divergence while using momentum indicators. Divergence in Moment Trading is when the price is moving in the opposite direction compared to the direction of the Momentum Indicator.
Consider the below example where EUR/JPY is making a Bullish Divergence on Monthly Chart. In January 2012 EUR/JPY closed at a low of 99.61 and in August 2012 EUR/JPY closed at a new low of 97.18. Whereas the RSI moved in the opposite upside direction, In January RSI was at 26.19 and in August RSI was at 31.67. By comparing the price chart with the RSI Bullish Divergence is evident and the EUR/JPY gave a strong Bullish Move after the divergence.
Similarly, in the case of Bearish Divergence, the Price moves in the upward direction making a new high whereas the indicator moves in the opposite direction making a new low indicating a Bearish Movement of prices in the future can happen.
Several Momentum-based indicators can be used for Momentum Trading. Some of the widely used and popular indicators utilized by Forex Trading are.
Momentum Trading Strategy for Forex Trading
Momentum Trading Strategies can be utilized by Scalp Traders, Day Traders, Swing Traders, and Position Traders as well. Forex traders applying Momentum Indicators and Strategies look for Currency Pairs that are moving in an up or downtrend. Currency Pairs that are trading sideways in range-bound sessions are not suitable for momentum trading. Momentum Traders look for strong Price Action.
Currency Pairs ideal for Momentum Trading should have strong charts on a particular timeframe that a trader has chosen. For Example, if the Forex Trader has chosen a daily chart then the currency pair should have a strong daily chart with solid Price Action.
The Currency Pair should have a high volume as compared to other currency pairs to have energy behind the movement. Large volume means more fuel behind the movement which will give a currency pair a huge thrust to move in a particular direction.
Lastly, if the Currency Pair is coupled with a Fundamental News Catalyst such as a change in Interest Rate, Inflation Numbers, GDP Forecast, or Current Account Deficit, it can act as a triggering point.
Benefits of Momentum Trading
- Consistent Returns
Traders going with the flow of momentum can generate quick and constant returns contrary to the trading strategies where the traders hold a Currency Pair. Momentum-based trading strategies can be more reliable if developed and applied correctly.
- Simple Market Analysis
Traders are focused on a couple of currency pairs and analyze them technically. Generally, momentum traders are not concerned about fundamental or overall markets around the world. They can easily concentrate on specific currency pairs for momentum trading.
- Strong Emotional Control
Momentum-based strategies are very tight and traders typically do not trade in every market condition. By following the strategy religiously momentum traders can control their emotions easily as they are entering and exiting the trades on very specific points.
Problems of Momentum Trading
- Fundamental Changes & News Risk
The momentum can be short-lived as the trend can break at any point due to News or any change in fundamentals. Unexpected News of any kind can cause the currency pairs to move the trend.
- Fake Momentum
Momentum is generated when value investors or institutions BUY OR SELL financial security with good volumes. These trades with volumes change the trend in the opposite direction. Sometimes these trend changes are fake. The currency pairs start to move in a trend slowly for a couple of sessions and immediately there is a huge buying or selling occurs causing a big dip with a trend reversal.
- Trend based Performance
Momentum trading is not suitable for all types of market conditions and trends. Momentum traders generally make more money in up trends as everyone is joining and buying making the movement stronger. In downtrends, people try to stay more cautious. Momentum traders can bear losses in range-bound and choppy markets as the indecisive markets cause false up or down trends.
Momentum Trading is trading in a particular direction once the trend has reversed. Sometimes these trends can be short-lived and the whipsaw effect can occur immediately.
Market makers know the market movements earlier than the retail traders and they can be planning the market movements with huge financial capital. These market movers can easily trap small traders and investors in false trends.
To tackle the market movers, a more conscious approach is required. Tight stop loss with a well-tested momentum-based trading strategy is required to earn good profit.
To enter or exit a trade, your move has to well plan ahead of time and clean execution is required once the trading setup is ready. You do not have to trade every time especially when the volumes are dry and markets are moving in sideways.