Momentum trading is a trading technique whereby traders choose when to buy and sell based on the strength and momentum of recent price trends. Momentum traders will choose assets that are moving strongly in given direction, making the assumption that they will continue in that direction, until it loses strength or ‘momentum’. Once they have identified a trend, momentum traders will then adopt a long or short position in the stock.
Momentum trading can be one of the most profitable trading strategies, however it is also one of the most difficult. To have a shot at success with momentum trading you must be extremely focused, disciplined and knowledgeable about the market to reach your targets. You must understand how to accurately spot assets with a powerful trajectory and watch them closely.
There are two key momentum trading systems:
A technical-based momentum trader will make their moves based on how they perceive the market at that time, using technical analysis. If they deem that the market prices are higher than they would expect they will short (or borrow) the stock and buy it later, whereas if the prices are lower than predicted, they will buy now and short at a later stage.
Event-based momentum traders decide which action to take based on market volatility, which can be caused by political turmoil, positive or negative news and unexpected events. Periods of intense volatility usually last for a number of hours, and this is when a momentum trader will execute their trades.
The formula for momentum is:
V= latest price
Vx = closing price
x = number of days ago
Momentum is usually measured over a period of 10 days. To calculate momentum, subtract the closing price 10 days ago from the last closing price.