A guide to Momentum Trading Leveraging Market Trends Technical Indicators
A guide to Momentum Trading: Leveraging Market Trends & Technical
Indicators
In essence, momentum refers to the rate of change of an instrument’s price over a specified
period. The stronger the momentum, the more rapidly prices rise/fall. The strategy of
momentum trading involves purchasing securities that show upward price movement and
then selling them when they appear to have reached their peak. The strategy attempts to
take advantage of market trends by investing in financial instruments showing strong price
movements. It also leverages the belief that these trends, driven by market psychology and
trading behaviours, are likely to persist for a certain period, allowing traders to potentially
profit from continued price momentum.
Momentum trading relies on technical indicators and analysis to identify and confirm trends.
These tools assist traders to measure the strength and sustainability of a trend and to
establish entry and exit points. Two key indicators used include:
- Moving Average Convergence Divergence (MACD): The MACD is a trend-following
momentum oscillator. Traders use MACD to measure the gap between two moving
averages of a financial instrument’s price, enabling them to determine the trend’s
direction and assess whether bullish or bearish momentum in the price is gaining or
losing strength. The indicator is also used to help traders identify market entry points
for buying and selling. The MACD is often displayed as a histogram that indicates the
prevalence of buyers or sellers in the market based on its unbounded oscillating slope.
An ascending MACD slope suggests a stronger presence of buyers, while a descending
slope indicates that sellers are more prevalent. The MACD also includes a signal line,
which is a smoothed moving average of the MACD histogram. This signal line produces
buy or sell signals when it crosses the histogram. For example, a buy signal is
generated when the histogram moves above the signal line, and a sell signal occurs
when the histogram drops below the signal line. - Relative Strength Index (RSI): This indicator captures the speed and change of price
movements of any given asset, momentum in other words and provides technical
analysts with valuable clues and hints about the strength of the momentum of the
current trend. RSI is a bounded oscillator whose values fluctuate between 0 and 100,
and traders use the 70 mark as a signal of overbought conditions and likewise the 30
level as a signal of oversold conditions, which allows them to act accordingly, taking
either long or short positions, depending on their style.
Like other trading strategies, momentum trading is at risk of being impacted by several factors
such as market volatility, overbought and undersold conditions, behavioural biases, and false
breakouts. Having a robust risk management plan in place to mitigate these challenges is
therefore crucial.