What is a Momentum Trading Strategy?

Momentum refers to the underlying direction of price action. Identifying Momentum and effectively trading it is a crucial element of profitable trading. IG Index 20181113 The chart for USD/JPY Mini shows that throughout 18 days the general price momentum was upwards. The price did move within a range indicated by the trend lines, and there were temporary reversals, but the overall move was from 112.1 to 114.0 If you had opened a long position at any price on 26th October and held the position until 13th November, you’d have made a profit. Momentum can, of course, apply to intra-day trading but as in the example above it is typically associated with a longer period of days or maybe weeks. Trade management might involve a risk-return target starting in the region of 1:3 with stop losses further out of the money and profitable positions allowed to run. While some Momentum trading strategies advocate additional trading to increase the size of profitable positions an alternative is to take profits over time and introduce trailing stop losses. Trade management that involves scaling out of a trade means any trade that is at one point profitable can be structured to at least break even.

Trading Momentum

Trading Momentum trading can be made challenging because of the different time horizons that apply to markets. Consider a situation where Hourly Momentum is bullish but Weekly Momentum is bearish. For a few hours during a particular day going long might be profitable as you ride the shorter-term momentum that is a reversal of the longer-term downward movement. If you do hold that position for longer than a few hours you might, however, see your once profitable position become part of the Weekly momentum pattern; for the price to fall away and your position to close out at break even or even at a loss. Trading using a Fading strategy is based around trading the shorter term move which is in the opposite direction to the longer-term trend. Your Momentum trading strategy should factor in what duration Momentum you are trading (hourly, daily, weekly, etc.) and the time target time for holding a particular position adjusted accordingly.

Quantifying Momentum

Trade entry points and capital allocated to any trade will be a function of the strength of the Momentum. Fortunately, there are indicators that allow the strength of the price action move to be graded:
  • You might want to look for the percentage move in price before there is a real pullback. A more significant move would be because of stronger underlying buying or selling.
  • The greater the increase in trading volumes the stronger the Momentum. Trading volumes which are x2, x3 or more than the average would be significant.
  • Breaking levels. Look for price action breaking through significant price levels such as Pivots and previous Highs/Lows.
  • News events that act as a catalyst are also signs that a significant change in price action is taking place.
  • Indicators such as RSI Index, Bollinger bands and Moving Averages are all used to grade the strength of Momentum.
Momentum trading requires specific market conditions which might not always be present. ‘Forcing’ your way into a trade that wasn’t there to be done can be costly as stop losses are usually some way behind entry price levels.