What Exactly Is Momentum Trading?
Momentum trading is a trading strategy in which traders buy and sell based on the strength of recent price trends. Price momentum is analogous to physics' momentum, in which mass multiplied by velocity determines the probability that an object will proceed on its direction. However, in financial markets, momentum is measured by other variables such as trading volume and the rate at which prices change. Momentum traders bet that an asset price that is moving strongly in one direction will continue to move strongly in that direction until the trend weakens.
When Did Momentum Trading Begin?
The custom of momentum trading dates back centuries. Famous British economist and entrepreneur David Ricardo was known to have used momentum-based trading strategies effectively as early as the late 1700s. He purchased stocks with strong price trends and then sold stocks with weak price trends. "Cut short your losses; let your profits run on," he said, describing the strategy.
Following the emergence of technical analysis in the late nineteenth century, well-known traders and analysts such as Jesse Livermore, HM Gartley, Robert Rhea, George Seaman, and Richard Wycoff used the concept of momentum in the 1920s and 1930s. Al**** Cowles and Herbert Jones, economists, were the first to formalize the concept in academic studies in 1937. They discovered that assets that performed well one year appeared to perform well the next year.
However, with the introduction and popularization of value investing theory beginning in the 1930s, the concept became blurred and dormant. Investors will be more concerned with an asset's intrinsic, or "fundamental," value rather than the price movement's trajectory. Following a resurgence in technical analysis later in the century, Jegadeesh and Titman's 1993 study resurrected the idea of momentum investing. It demonstrated that traders and markets continued to provide constructive input to recent information about asset prices, confirming current price trends.
What Precisely Are Momentum Indicators?
Momentum indicators are technical analysis instruments that are used to assess the price strength or weakness of a stock. Momentum is the pace at which stock prices rise or fall. The relative strength index (RSI) and moving average convergence divergence are two common momentum indicators (MACD).
Identifying Momentum Indicators
Momentum is the pace at which stock prices rise or fall. Momentum is a very valuable indicator of the strength or weakness of an issue's price when it comes to trending. History has shown that momentum is much more useful in growing markets than in declining markets; this is due to the fact that markets grow more often than they fall. In other words, bull markets usually outlast bear markets.
The Benefits of Using Momentum Indicators
Momentum indicators depict price movement over time and the strength of such movements, regardless of whether the price moves up or down. Momentum indicators are particularly useful because they assist traders and analysts in identifying points where the market can and will reverse. Divergence between price movement and momentum is used to identify the points.
Since momentum indicators display the relative strength of price movements but not their directivity, they are best used in conjunction with other technical indicators that show price trends and directions, such as trend lines and moving averages.
Divergence occurs when, for example, the price of a stock is steadily falling, following the momentum indicator (which implies strong momentum), but then the momentum indicator shifts to the upside or no longer follows the downward price movement. It shows that the indicator has diverged from the price movement and that the current price movement's momentum is failing.
The chart below shows how the Relative Strength Index (RSI) momentum indicator predicts impending price direction shifts in the AUD/USD currency pair as its movement diverges from the direction of price movement.
Divergence is usually an indicator that the current price trend is likely coming to an end and is about to reverse due to the signal that momentum is stalling. A bullish divergence occurs as price movement and momentum diverge upward. A bearish divergence would occur if price movement and the momentum indicator were still consistently heading upward and the momentum indicator unexpectedly shifted to the downside.
Common Momentum Indicators
Traders can employ a wide range of momentum indicators. There are, however, a few that are extremely common among traders and are commonly used.
Finally, the ADX (Average Directional Index) should be listed. In fact, the Directional Movement System – comprised of the ADX, the Minus Directional Indicator (-DI), and the Plus Directional Indicator (+DI) – was developed by Welles Wilder as a community that could be used to help quantify both the momentum and direction of price movements.
- Moving Average Convergence Divergence (MACD)
One of the most widely used momentum measures is the Moving Average Convergence Divergence (MACD). The MACD employs two indicators – moving averages – and converts them into oscillators by subtracting the longer average from the shorter average. That is, the MACD shows momentum by oscillating between moving averages as they converge, overlap, and move away from one another.
As previously mentioned, the MACD employs two moving averages. Although it is entirely up to the trader or analyst, the measure usually employs the 12-day and 26-day exponential moving averages (EMAs), with the 26-day being subtracted from the 12-day. The result is the MACD line, which is then usually graphed with a 9-day EMA to serve as a signal line capable of identifying price movement turns.
The histogram, which shows the difference between the MACD line and the 9-day EMA, is the most significant feature of the MACD. When the histogram is positive – above the zero-midpoint line but falling towards the midpoint – it indicates a weakening uptrend. When the histogram is negative, below the zero-midpoint line, but starts to ascend towards it, it indicates that the downtrend is weakening.
- Relative Strength Index (RSI)
On a chart, RSI assigns a value between 0 and 100 to stocks. Analysts equate these figures to other variables, such as undersold or underbought values, after they have been charted. Experts typically chart the RSI on a constant rather than hourly basis to achieve the best evaluation. Shorter hourly intervals, on the other hand, are often charted to suggest whether it is a good idea to make a short-term asset purchase.
Another common momentum indicator is the Relative Strength Index (RSI). The RSI, which is also an oscillator, serves as a metric for price changes and the rate at which they adjust. The indicator alternates between zero and one hundred. Traders and analysts will detect signals by looking for divergences, failed oscillator swings, and when the indicator crosses over the centerline.
Any rising RSI value above 50 indicates positive, uptrend momentum; however, if the RSI reaches 70 or higher, it is often an indicator of overbought conditions. RSI readings that fall below 50, on the other hand, indicate negative, downtrend momentum. However, RSI readings less than 30 indicate potential oversold conditions.
- Average Directional Index (ADX)
The ADX is calculated from the smoothed averages of the -DI and +DI, which are calculated by comparing two consecutive lows and peaks. The index is a component of the Directional Movement System that measures the strength of a trend regardless of its direction. It's worth noting that ADX values of 20 or higher indicate the existence of a trend. Any reading less than 20 indicates that the market is “directionless.”
Momentum indicators are important tools for traders and analysts, but they are seldom used alone. It is more popular to use them in conjunction with other technical indicators that show trend directions. Momentum indicators are useful after a direction has been decided because they reflect the strength of price movement trends and when they are about to stop. You may visit INSTAFOREX to learn more.