Traders are always looking to market trends as a way of determining the best time to take or relinquish a position. Momentum trading is a tactic that capitalizes on new and rising trends, in particular, to allow traders to maximize their profits. In order to succeed, traders must carefully evaluate emerging market trends to minimize any risk.
The following guide will detail how to calculate momentum and how to find momentum stocks for swing trading.
What Is Momentum Trading?
Momentum refers to the rate at which a price is changing in the stock market, whether upward or downward. It is also often used to refer to how quickly a particular trend is accelerating. In momentum trading, investors seek to buy stocks that are showing strong upward momentum. They then sell these stocks when their prices are at their peak.
For example, some point to AI developments and alternative-fuel vehicles as contributing to the momentum of the tech and transportation sectors. As such, investors might seek to use those innovations to fuel their own portfolios.
Ultimately, momentum traders are interested in three key dynamics: volume, volatility, and the time frame for the investment.
Volume
Volume is particularly important in momentum trading, as traders need to be able to offload their shares when the time is right. When a high number of investors are actively trading on a particular asset, traders have a better chance of selling their shares quickly.
Volatility
Momentum traders count on volatility to drive prices up. High volatility can translate to major price swings, and momentum traders can capitalize on said swings for substantial profits. The obvious downside, however, is that doing so requires a risk management strategy to protect themselves against major downturns.
Time Frame
Stock market momentum is time-limited, which means traders have to watch the time frame in which a trend rises and falls. In other words, momentum investing tends to favor day trading strategies, though some longer trends can still be used in position trading.
Technical Indicators for Momentum Trading
As a means of identifying and measuring market trends and truly understanding stock momentum, traders rely on a series of tools known as momentum indicators (MOMs).
These indicators work in several distinct ways to measure the difference in an asset’s current closing price and the closing price from a specified number of days ago. By determining how much and how fast a security’s price has shifted, traders can predict continuations or reversals in price trends and time the market more accurately.
Some common MOMs used in momentum trading are as follows:
Relative Strength Index
Traders look to the Relative Strength Index (RSI) to determine the speed and change of price movements. The RSI is a momentum oscillator that will provide a score on a scale of 0 to 100. These scores, in turn, can point to overbought or oversold conditions on the trading of an asset.
Momentum traders typically look for an RSI score below 30. That will indicate that the asset is oversold, which means that the price will be undervalued. On the other hand, RSI scores over 70 indicate that an asset is overbought, which may be used as a sell signal.
Moving Average Convergence Divergence
The Moving Average Convergence Divergence (MACD) is a momentum indicator that focuses on the correlation between two moving averages of an asset’s price. By deducting the 26-period Exponential Moving Average (EMA) from the 12-month EMA, the result will yield the MACD line.
Traders then plot the “signal line,” which is the nine-day EMA of the MACD itself. When the MACD line intersects above the signal line, it’s considered to be a bullish trend, which may prompt momentum traders to buy an asset. Conversely, crossing below the signal line may indicate that it’s time to sell.
Stochastic Oscillator
A stochastic oscillator (SO) compares the closing price of an asset to a range of prices in a given period. Momentum traders can adjust that time period to reduce the SO’s sensitivity or to take a moving average of the results.
Additionally, momentum traders use the stochastic oscillator to generate a value in a range from 0 to 100. Oversold conditions, which tell traders to buy, are indicated by values below 20. Overbought conditions, which trigger traders to sell, are indicated by values over 80.
Average Directional Index
The Average Directional Index (ADX) is a technical indicator that momentum traders can use to determine the strength of a trend, regardless of whether the trend is traveling upwards or downwards.
The ADX relies on two lines plotted on the same graph: the Positive Directional Indicator (DI+) and the Negative Directional Indicator (DI-). ADX values over 25 indicate a strong trend, which can help momentum investors understand just how much momentum is backing a current trend.
Rate of Change
Investors use the rate of change (ROC) to determine the change in percentage between an asset’s current price and its price from a set number of periods ago. The ROC is particularly useful because it can show divergences between current and historical prices, as well as identify overbought or oversold crossovers.
Momentum traders are particularly interested in centerline crossovers, which occur when the ROC crosses above or below the zero line. These can indicate a potential buy or sell signal, depending on whether the crossover is occurring in a bullish/bearish direction.
Momentum Trading Strategies
If you’re looking to get the most out of your momentum investment strategy, here are some trading tips that both swing traders and day traders can use to optimize their gains while avoiding major risks:
Use Multiple Indicators
Technical indicators aren’t meant to be mutually exclusive. The ones outlined above can (and should) overlap and reinforce each other. To that end, traders should get used to comparing the data across multiple indicators in order to make their decisions based on the best possible data.
Determine Entry and Exit Points
As explained earlier, a large part of momentum trading is timing. Traders should, therefore, rely on things like the stochastic indicator to determine when a security is overbought or oversold. Exit points can also be determined by your individualized investing goals, such as when your returns reach a certain target percentage.
Focus on Earnings Momentum
Where and whenever possible, invest in companies with reported earnings that surpass analyst expectations. Historic performance may be the most valuable indicator of continued price momentum, and it may also indicate high liquidity, meaning you’ll have a stronger chance of finding buyers when you’re ready to exit your position.
Manage Risk Effectively
All forms of trading come with some degree of risk, but short-term traders can be particularly vulnerable to price swings in a volatile market. As such, traders should use some basic strategies to mitigate that risk.
For instance, never invest more than 1% of your trading budget in a single trade. Use stop-loss orders to mitigate losses from an underperforming asset. And understand that day trading might best be reserved for after you’ve achieved a balanced investing portfolio.
Continuous Learning
Traders achieve the best results when they stay informed about market conditions and industry trends. Always seek to learn more about technical indicators, as well as industry trends, that might influence the momentum of a stock. Adjusting your trading position to keep up with these changes can improve your trading performance and protect you against risk.
Stay Informed About Market Performance
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