Momentum Trading for Beginners: Things You Need to Know
Market prices can go up and down in a matter of a day or even minutes. Momentum traders are using these price movements to jump on the market and make a profit. But it’s not that simple.
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In this article, we’ll go over the following aspects of momentum trading and how it works in crypto:
- What is momentum trading?
- Where is momentum trading used?
- How to separate noise from momentum?
- What are the indicators of momentum?
- How well does momentum trading work in crypto?
- Is momentum trading a profitable strategy?
- How to know if momentum trading is the right strategy for you?
What Is Momentum Trading
In physics, momentum is the amount of motion that an object has. Isaac Newton proposed that the momentum of a system is constant if no external forces are acting on it.
Momentum traders interpret this concept in markets as the speed at which an asset’s price moves. The idea is that if the price is rising it’s likely to continue rising, and vice versa.
So, the goal of momentum trading is to make a profit by moving with the market direction. That is: buy assets when prices are rising and sell when they are falling.
Compared to long-term strategies like the popular buy and hold, momentum trading is a short or medium-term strategy. It’s primarily based on technical analysis as traders need to evaluate performance metrics to identify price directions.
By its nature, momentum trading is also opposed to value investing which aims to find and invest in undervalued assets.
Having been used for decades, momentum trading was popularized in the 1970s by American fund manager Richard Driehaus.
The fund manager explained his philosophy with the sentence:
I would much rather invest in a stock that's increasing in price and take the risk that it may begin to decline than invest in a stock that's already in decline and try to guess when it will turn around,
Source: “The New Market Wizards Book” by Jack Schwager.
Where and How Is Momentum Trading Used?
Momentum trading is a general strategy that you can use in stocks, crypto, commodities, forex, and other markets. It works particularly well in extreme market conditions where traders can catch the trend and capitalize on the market movements.
This works both ways: finding assets that are big gainers in their categories or zooming in to analyze the performance of a specific asset, for example, Bitcoin, over time.
That being said, there are different types of momentum:
- Positive price momentum: when the price consistently moves up over a certain period of time
- Stalled momentum: when an asset doesn’t move in any clear direction. This happens especially after a period of positive momentum when the movement starts to stabilize.
- Negative price momentum: when the price consistently moves down over a certain period of time
A red or green chart itself doesn’t mean a momentum has formed.
There are key technical and price levels an asset needs to break through to start a true momentum.
This leads us to the next question: how to spot momentum and which indicators to consider.
How to Separate Noise From Momentum and Which Indicators to Look At?
It can be an easy mistake to take random price movements for momentum. For example, the price may rise as a result of whales’ purchase and cool off pretty soon. This can give false signals to traders, and distort the picture of a market.
To define if it’s noise or a true momentum, traders may choose to wait a little while to see how the trend works out. There is no fixed time for this waiting.
Based on your strategy and the market volatility, you may decide to hold off from several minutes to several days or weeks. For example, day traders, who make multiple transactions in a day will choose shorter timeframes while swing traders, who hold their positions for a few days, may wait longer for market adjustments.
On one hand, jumping on board early, you’ll gain an advantage if the momentum proves to be true, but on the other hand, you’ll take higher risks. As there are no certain answers when is the right time to enter the market, every trader can practice different approaches to see what better fits their goals.
Several factors come together to form a momentum.
To identify momentum based on data and technical analysis, consider these indicators :
- Traded Volume: Analyzing volume along with price movements will help you confirm the momentum or reveal that something is wrong. For example, a price spike with low or below-average traded volume suggests that the move lacks strength. Meanwhile, the upside price trend going with above-average volume creates a bullish momentum.
- Relative Strength Index (RSI): This indicator shows the speed and magnitude of price movements on a scale of 0-100. Typically, the RSI is calculated over a 14-day period to signal overbuying or overselling. An RSI below 30 indicates overselling, while an RSI above 70 means overbuying. In these cases, you can expect a price reversal. On the other hand, a more stable RSI reflects stronger or more consistent market momentum.
- Resistance and Support Levels: The battle between upward and downward trends is generally decided by these key price levels. In momentum trading, support and resistance are critical, as they can indicate areas where momentum might slow, reverse, or grow. If an asset breaks the resistance level, it suggests a strong upward movement, while falling below the support level indicates a downward trend.
- Moving Average Convergence Divergence (MACD): The indicator may seem complex, but not so much if you break it down. A moving average represents the average price of an asset over a period of time. There are two types of moving averages: Simple Moving Average (SMA) and Exponential Moving Average (EMA). The difference is that the SMA averages all prices across the previous days, while the EMA gives more weight to recent price updates.
MACD measures the relationship between two EMAs, most commonly the 26-period EMA (longer-term) and the 12-period EMA (shorter-term), to define the strength of the prevailing trend and signal changes. These parameters can be adjusted to other timeframes based on the trader’s preference.
The MACD is presented on charts as a line that moves above and below a baseline representing the 0 value. MACD is derived by subtracting the longer-term EMA from the shorter-term EMA of the price. If the value is below zero, this indicates a downward trend. When the MACD line is above the baseline, it indicates an upward trend.
Another component of the MACD is the signal line, which is displayed on top of the MACD line and is typically the 9-day EMA. When the MACD is above the signal line, it suggests bullish momentum; when it is below the signal line, it indicates bearish momentum. The crossover between the MACD and signal line suggests a possible change in trend.
MACD is usually depicted as a histogram, a type of visual data representation using bars.
How Well Does Momentum Trading Work in Crypto?
For momentum trading, assets like cryptocurrencies and tech stocks are a good fit due to their volatility. These classes often show strong momentum patterns, providing traders with opportunities to make profits.
Momentum trading works well in crypto due to the sector’s dynamism. Operating on-chain and without intermediaries allows the crypto market to function non-stop, meaning momentum traders can make transactions anytime they wish.
Though crypto is a well-suited market for momentum trading, there’s a twist:
Momentum trading doesn’t guarantee 100% gains, no matter how well a trader has analyzed technical indicators.
Whether in crypto, stocks, forex, or other markets, it’s essential to remember that some assets carry higher risks than others. When choosing a momentum trading approach, be prepared to adjust your tactics regularly, as markets, especially crypto, don’t stay still.
Related: Crypto vs. Forex: What’s the Real Difference for Investors?
Is Momentum Trading a Profitable Strategy?
Momentum trading can be profitable but it can fail because of the difficulties of predicting whether the trend will repeat itself or take another direction.
There’s no proven recipe for how to ride the waves of momentum as chasing only trends can lead to failure.
There are at least 3 things to look at when you practice momentum trading:
- How to find great trading assets
- How to reduce the chances of losses
- How to choose and adapt your strategy
Starting from the first, you’ll need to filter the market and decide on the asset categories and assets you prefer to trade. Say, you want to practice momentum trading in crypto. According to CoinMarketCap, there are more than 2,4 million cryptocurrencies as of October 2024.
You’ll need to choose if you want to invest in trending categories like memecoins, established cryptocurrencies like Bitcoin or Ethereum, diversify your portfolio, or consider any asset with an upward trend. Each choice comes with its pros and cons.
To reduce the chance of losses, you can consider combining momentum trading with other approaches. Besides decoding technical indicators, pay attention to fundamental analysis to understand the root causes behind the market movement, including the real value of an asset, factors that influence the price, and the overall psychology behind the forces that drive prices up or down.
Two key points in momentum trading strategy are when to enter and exit the market. For this reason, you need to define your risk tolerance, how quickly you’re going to respond to new trends, and the point you’ll take the profits to avoid losses.
Plus, there’s a need to keep an eye on the recent developments to review your tactics whenever there’s a need. Turning on notifications or using trading bots can help monitor the market.
One more thing: don’t forget about the fees.
To understand whether you’re profitable or not, you need to calculate the fees you will pay for transactions.
The Trading Mentality: Is Momentum Trading Right for You?
There’s a common misunderstanding about trading: it’s often seen as a game. But it’s rather a business that requires a deep understanding of the market and psychological preparedness in case your approach doesn’t work out.
Jumping into the market without understanding it and considering the risks can be a costly mistake, especially if you want to make trading your full-time or part-time career. So, you need to take time for research and education.
There are multiple theories to study, such as buying low and selling high, which may suit you if you’re ready to analyze the market, respond to changes, and develop emotional resilience.
If you’re looking for strategies that don't require constant market evaluation, passive trading like buy and hold may be a better fit.
Related: Trader’s main psychological traps and how to deal with them
FAQ
- What Is Momentum Trading?
Momentum is a force that sustains and accelerates movement. The momentum trading strategy suggests that if the price is rising, it’s likely to continue rising, and vice versa. Therefore, momentum traders follow trends, making buying and selling decisions accordingly.
- What Are Common Mistakes in Momentum Trading?
Among the common mistakes are falling for bull or bear traps. Technical indicators may point to a bullish market with rising prices, only for the price to drop sharply later. The same applies to bear markets, where traders may sell only to find that the price grows again. Careful analysis and allowing the trend some time for a possible pullback can help avoid this.
- Is Momentum Trading a Popular Strategy?
Yes, momentum trading is a popular strategy for both retail and institutional traders. It’s used in various markets, including stocks, crypto, and forex.
- What Other Trading Strategies Are There?
Other popular strategies include value investing, where traders find and invest in undervalued assets with growth potential; counter-trend investing, where investors buy at low prices and sell at high levels; and the buy and hold strategy, which suggests holding positions for a long time.
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