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Momentum Trading: Types and Strategies

by Sneha Shukla

Momentum trading is a popular approach used with respect to short-term trading. It involves the concept of identifying dynamic asset prices and capitalizing on these changes by setting positions with the predicted price movement. 

Momentum trading is a strategy that builds on the momentum of financial markets. It is a dynamic approach to leverage the ongoing price trends. Let us understand the best momentum strategy and its fundamental principles.

What is Momentum Trading?

Momentum trading includes buying and selling assets based on the current price trends. This allows traders to maximize returns by following the ongoing trend. As such, you can study assets in the short term and buy the assets when prices are rising. Then, you can go ahead and sell those assets when the prices start becoming weak. 

How Does Momentum Trading Work?

The financial market has become quite unprecedented lately. Still, the best momentum strategy will involve the following elements:

 

  • Selection of the assets you wish to trade
  • Knowing when you should exit
  • Sizing the positions correctly
  • Getting on each trade timely

The most challenging aspect of momentum trading is identifying trends. You can easily identify trends by analyzing past performance (like 52-week highs and price returns of 20 days). Effectively, the assets that reveal the strongest signals depending on technical indicators will come to the top of the list, depicting the best possibility for maximum gains.

Even as you continue identifying trends and entry points, you are still expected to analyze the best exit points. Experienced momentum traders tend to plan the ‘end’ of each trade before they make any move. You are expected to identify the exact point at which you will be taking profits and when you will exit with a loss.

Once you have selected your preferred assets, exit points, and entry points, you can start building the best momentum strategy with the help of a third-party platform.

 

  • Spotting High Price Trends: Momentum traders search for assets exhibiting strong price movements in a specific direction over a particular period of time, like days, weeks, or months. They usually emphasize assets with major price momentum, either downwards (bearish) or upwards (bullish).

 

  • Setting Entry & Exit Points: Experienced traders set particular criteria when it comes to entering and exiting trades depending on their trading strategy and selected indicators. 

 

  • Leveraging Technical Indicators: Traders usually leverage technical indicators for confirming price momentum and identifying possible entry & exit points. Some of the common indicators include RSI (Relative Strength Index), moving averages, MACD (Moving Average Convergence Divergence), and others. These indicators help traders analyze the direction and strength of the price trend.

 

  • Management of Risk and Position Sizing: Risk management is pivotal in momentum trading to prevent losses. Traders usually set stop-loss orders to minimize potential losses while leveraging position-sizing techniques to streamline the amount of capital allocated to each trade.

 

  • Adapting to Changing Market Conditions: Traders also continuously assess existing market conditions and adjust the respective strategies to leverage new opportunities or minimize risks. 

Types of Momentum Trading

  1. Cross-sectional Momentum

In this type of momentum trading, traders consider comparing the performance of assets with respect to each other within the given portfolio. Traders go ahead and rank assets depending on their recent performance. 

Top-performing assets are purchased. On the other hand, bottom-performing assets are avoided or sold. The emphasis is on the selection of assets with the best relative performance when compared with the peers.

  1. Time-Series Momentum

In this type of momentum trading, traders analyze the historical performance of individual assets over a particular period of time. Traders spot assets that have fulfilled a specific threshold of percentage profit over a given historical period, like the past six months or twelve months. 

Assets that exceed the threshold are bought, predicting that the positive momentum will continue. The emphasis is completely on the performance of each asset with respect to its own historical performance.

Factors That Affect Momentum Trading

The short-term change in an asset’s price is determined by several factors. 

  • Market Condition: The overall market condition, including volatility, trends, and liquidity, is capable of impacting momentum trading. Markets that are strongly trending and feature low volatility usually offer favorable conditions for pursuing momentum trading.

On the other hand, range-bound market conditions with high volatility might lead to false signals and impose challenges for traders.

  • Risk Management: Effective risk management is pivotal for minimizing losses and saving capital with respect to momentum trading. For instance, trend following practices can be significantly risky. This is because they depend on trends continuing in the given direction.

Traders are expected to implement risk management strategies like position sizing, setting stop-loss orders, and ensuring diversification to manage risks. 

  • Market Sentiment: This factor includes aspects like sentiment indicators and investor sentiment. These aspects are capable of influencing the strength and direction of the price trends. For instance, bullish sentiment can accelerate upward momentum. On the other hand, bearish sentiment can lead to downward momentum. 

Traders usually analyze market sentiment indicators, including sentiment indices, surveys, and options positioning. This helps them analyze market sentiment and search for possible trading opportunities. 

 

  • Regulatory Factors: Policy decisions, regulatory changes, and interventions by government authorities or central banks, can affect market dynamics while disrupting existing trends. 

Momentum traders are expected to be informed about ongoing regulatory developments while anticipating potential outcomes on asset prices. Regulatory interventions or announcements can lead to immediate accelerations or reversals in momentum. This requires traders to react smoothly while adjusting their positions.

Conclusion

If you wish to attain success in momentum trading and garner ample knowledge about it, look no further than Wright Research. The expert opinions of trading specialists here are backed by revolutionary artificial intelligence, which makes them unique in the competitive era. 

Momentum trading, like all other trading strategies, requires in-depth consideration of benefits and risks. It also requires a disciplined approach to trading. You can ensure the same with guided help from the experts at Wright Research -your one-stop destination for financial expertise. 

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