Momentum Trading Explained: Your Guide To The Basics

Summary:

Momentum trading is an investment strategy capitalising on recent price trends. It involves buying high to sell higher. It's dependent on understanding the psychology of traders and reading market momentum. You can adopt a long-term or short-term strategy based on volume, volatility, and time frames. In this dynamic world, whatever direction you choose to go, you must be cautious.

“Buy low and sell high” is a popular stock trading adage that you must be familiar with. However, some traders like to buy high and sell higher. That’s exactly what momentum trading is. Let’s dive right in, and give you all you need to understand the basics of momentum trading.

What is momentum trading?

Momentum trading is an investment strategy involving buying and selling an asset based on recent price trends. The idea here is to take advantage of the momentum in the price movement.

While this is short and simple, you can understand better in the following sections.

How does momentum trading work?

The strategy behind momentum trading is taking advantage of the market’s existing trends.

In other words, if an asset’s price has been rising, traders will buy it hoping it continues to rise. If the price has been falling, they might sell it, predicting it will only go lower.

The concept is that if a force is pushing the price in one direction, it's likely to keep going for a while.

The underlying idea is that stocks often take time to reflect their true value, and tend to move in one direction for a longer time.

When an asset's price is high, it usually grabs the attention of investors and trades, pushing to increase the market price. This goes on until a sizable number of sellers enter the market. When there are enough sellers, the momentum changes direction, which forces the price of the asset to lower.

Momentum traders are out to identify the strength of a trend in a given direction. Once they do, they benefit from the price change either by buying or selling, depending on the trend’s direction. The aim is to take part in the price movement and make profits until the trend lasts and close position when the trend’s strength is lost.

The main focus of a momentum trader is not necessarily the highest or lowest point of a trend, but the main body of the price movement. The main objective is to put to good use market sentiment and herding (all traders moving in a particular direction).

Ways to trade on the momentum

Primarily, there are two ways to trade on momentum:

1. Short-term momentum trading

Often called day trading, this focuses on short-term price trends ranging from a few minutes to hours, and sometimes days. Here, it’s important to monitor the market actively and quickly capitalise on price movements. This method involves analysing technical indicators and charts to pinpoint stocks that show movement. Typically, at the end of the day, day traders close their positions to steer clear of market fluctuations and overnight risks.

2. Long-term momentum trading

Here, traders work with the long-term in mind, i.e. weeks to months. They identify longer-term upward or downward trends in the market. With the extended time in hand, traders can weed out the volatility that’s frequently connected with shorter time frames. They use a combination of fundamental analysis with technical analysis .

Factors that affect momentum trading

Three important factors - time frame, volatility, and volume influence momentum trading.

• Time frame

There’s no fixed time frame for movement. How long the trade lasts depend on how strong the trend remains. So this works for both short-term and long-term traders.

• Volatility

Volatility is the degree of change in the price of an asset. When the market has low volatility, it means prices are lower or stable, while high volatility means there are significant fluctuations. Momentum traders seek volatility, so they can make the most of an asset’s value with the rise or fall.

• Volume

Volume refers to the number of assets traded in a specific time frame, and not the number of transactions. For instance, five buyers purchasing two assets each is the same as one buyer purchasing ten same assets.

Volume is essential because traders must quickly enter positions and exit, which relies on a stream of steady sellers and buyers in the market.

Examples of momentum trading

For better understanding, here are two examples.

Example 1: Positive momentum trading

Say you’ve been tracking the stock of a ‘Company A’ for a few months, and it’s showing a consistent upward movement.

• Entry point - You decide to buy 100 shares of Company A at its current price of Rs. 500 per share.
• Hold and monitor - You hold on to the shares and closely monitor the price movement for any change along with any financial reports related to Company A.
• Exit point - The stock price continues to rise and reaches Rs. 600 per share. You decide to sell your 100 shares, making a profit of Rs. 100 per share. This way, your total gain is Rs. 10,000 (100 shares x Rs. 100).

Example 2: Negative momentum trading

Say you’ve been tracking the stock of a ‘Company B’ for a few months, and it’s showing a downward movement.

• • Entry point - The current market price is Rs. 1200 per share. You decide to sell short (borrowing shares from a broker and selling them in the market with the intention of buying them back later at a lower price) 100 shares.
• Hold and monitor - In the coming weeks, the price further declines to Rs 1100 per share.
• Exit point - You decide to buy 100 shares back at the present market price of Rs. 1100 and close your short position. Meaning, you’ve made Rs. 100 per share profit (Rs 1200 - Rs 1100) giving you a gain of Rs. 10,000.

The bottom line

Successful momentum traders must balance risk management, analytical thinking, and timing. In this high stakes game, fortunes can change with the snap of a finger, making strategy, discipline, and knowledge essential. While buying high and selling higher can be extremely exhilarating, underneath lies a layer of caution that you must be wary of.