First, traders must understand what the word “momentum” actually means in practical terms. For these purposes, a straightforward definition of the concept can be interpreted as follows:
Momentum = Underlying Trend Strength
Let’s consider the market price activity that’s visible in three different examples:
In our first example, we can see a market showing positive price momentum. In this case, the asset is consistently holding above its 200-period exponential moving average (EMA) while its trend direction continues moving higher.
In our second example, we can see a market showing negative momentum. In this case, the asset consistently holds below its 200-period EMA while its broader trend direction continues moving lower.
In our third example, we can see a market with no clear directional momentum. In this case, the asset prices consistently oscillate around (above and below) its 200-period EMA. Prices are essentially trading in an erratic fashion (while moving sideways) and it can be said that there is no significant trend momentum that is dictating the value of the asset.
Absolute Momentum vs. Relative Momentum
Momentum readings can be further classified into two distinct categories: Absolute momentum and relative momentum.
- Absolute momentum: market behavior in the price of an asset is based on its relationship to past performances using historical time sequences.
- Relative momentum: market behaviors in the prices of individual securities are compared with one another (showing relative strength that differentiates between strong-performing assets and weak-performing securities).
Basic Elements of Momentum Trading
Momentum trading requires strict risk management rules capable of addressing changes in market volatility, price traps, and overcrowding in individual assets. Each of these factors can (and will) reduce a trader’s profit potential if the are managed ineffectively. Unfortunately, many traders routinely ignore the basic factors that lead to sustained price changes in the market. In most cases, these unsuccessful traders are blinded by a fear of missing the next big rally (or market sell-off) while the rest of the trading community shares in the windfall profits.
The basic elements of momentum trading can be deconstructed and broken down into five key elements:
- Selection – specific assets chosen to trade
- Risk – use of protective stop losses which define potential loss parameters
- Entries – timing used when opening trades
- Position management – consistently monitoring the market for possible changes in the outlook or positioning stance
- Exits – timing used when closing trades
Momentum strategies can be implemented on intra-day time frames (i.e. minutes or hours) but are more often utilized over longer time periods (i.e. weeks or months). The first step in the process is to determine the market’s dominant trend direction. In the three chart examples shown above, this was accomplished using the broad location of price activity in relation to each asset’s 200-period moving average. However, this can also be accomplished using the popular chart oscillators that are available on most trading platforms.
Momentum Oscillators
Momentum oscillators are common trading tools used to determine the underlying trend strength in the price of an asset. These oscillators give traders an objective visual representation of the speed at which asset prices are moving in any particular direction. Additionally, these momentum oscillators provide traders a better sense of whether the trajectories seen in recent trend movements are likely to continue in the future.
Momentum oscillators typically function as Rate of Change (ROC) price indicators. Momentum oscillation tools show the trend velocity of an asset as price movements reach maximum levels (and peak) before slowing and reversing. Common trading terms in these situations include “overbought” readings and “oversold” readings, which are both indications of asset price extremity.
When there is reduced potential for continued price momentum in the market, the diminished outlook tends to discourage investors from establishing new positions. In many cases, this will ultimately lead to reversals in trend activity. In the examples that follow, we will take a look at some of the ways common momentum indicator tools can be used by technical traders and see how their readings can be applied to successful strategies in momentum trading.
Momentum Trading Concepts
The Average Directional Index (ADX) is a popular trading tool that is used to determine the trend momentum of an asset. The ADX reading plots strength in price trends based on a range of values that fluctuate between 0 and 100. ADX levels under 30 indicate sideways activity (no clear direction in price action). In some cases, traders will refer to these types of conditions as an “undefined” trend.
ADX levels above 30 indicate a strengthening trend activity (without specifying a particular direction). In other words, the trend might be bullish or it might be bearish —all we know its reading is that the underlying trend is gaining strength. In the example below, we can see how the ADX metric behaves as trend momentum gains strength and eventually reverses course.
To the left of the price chart, we can see that asset prices begin moving in an upward direction after reaching swing lows. As the ADX value rises toward 100, we can see that the underlying trend momentum visible in the charted price action is also strengthening. In this example, ADX readings rise more forcefully as asset prices move above the 200-period moving average. This essentially gives us two independent pieces of evidence that suggest strength is building in the underlying price trend and this confluence helps make a solid argument to initiate long positions. Specifically, long trades could be opened as ADX readings begin to rise and price action breaks above its 200-period moving average.
Near the middle of this price chart, however, ADX trend momentum begins to slow. This event should act as a warning signal for traders holding a bullish position. In this case, readings in the ADX begin to drop (along with the underlying market valuation) until prices eventually fall through the 200-period moving average. As this occurs, readings in the ADX also move below the 30 level. This suggests that the previous bull trend is no longer in place and that general momentum in the market has diminished. At this stage, it makes sense to close any open long positions because there is no underlying trend to increase the probability of success and profit.
Next, we will look at a visual representation of the Commodity Channel Index (or CCI). The CCI tool is a momentum oscillator that compares the “common price” of a security to potential divergences from its simple moving average (SMA). Similar to the Stochastics oscillator, the CCI is designed to show conditions which suggest that an asset might be oversold or overbought. CCI readings that are above the +100 level are indicative of overbought market conditions while readings below the -100 level indicate oversold market conditions.
In the chart example shown above, bearish readings in the CCI hit “overbought” territory and asset prices continue moving forward in a new downtrend (which was originally projected by the momentum oscillator). Price activity below the 200-period moving average combined with a bearish reading in the CCI oscillator would give momentum traders sufficient reason to initiate short positions on this selected time frame.
The Relative Strength Index (RSI) measures the underlying “strength” of the market’s recent price movement relative to the activity shown in prior time periods. Essentially, the RSI is designed to show whether current price trends are sustainable (based on previous momentum performances). In the chart above, we can see three examples of oversold indicator readings which occur in the midst of an uptrend (projecting positive price momentum in the future).
As the dominant price moves are bullish, reversals in the RSI momentum oscillator suggest selling pressure is likely to come to an end. This opens the door to establish long positions, and protective stop losses can be placed below the support levels (white lines) that accompanied each upside trading signal in the RSI. Ultimately, this chart example shows three possible instances in which market traders could have established long positions while the underlying bull trend was still gaining momentum.
Next, we will look at the On Balance Volume (OBV) indicator, which measures trading volumes in relation to the price of an asset. The main principle behind the OBV indicator is that significant increases in trading volume often precede larger changes in the market’s underlying price valuation. As an early indication of changes in trend momentum, the On Balance Volume reading can be a valuable tool when determining which trading stance is most likely to generate profits.
In the chart shown above, we can see that On Balance Volume readings begin to rise even before a strong rally fueled by bullish momentum is able to send share prices higher. Momentum traders watching this information in its early stages could have established long positions with stop losses placed below the lows which preceded the changes in market volume.
Real-Time Trading Examples: Momentum Trading
Now that we have an understanding of the ways popular technical trading tools can send signals, it’s a good idea to see real-time trading examples that establish ground rules for entry and exit points. Our goal is to see several elements in the price chart history which would have allowed us to structure a profitable trade. First, we will look at a simple momentum trade that is based on the activity of exponential moving averages (EMAs). As crude oil prices fall below the 200-EMA, a short trade can be established at $57.20.
Stop losses would be placed above the prior highs (visible at $58.60). Profit target for the short position on crude oil is set at least 3x the trade’s potential for loss. Once markets have reached these levels, close the position for a profit.
Next, we will look at an example that bases its outlook on chart trendlines. As an upward trendline emerges, expert traders would see the changes in market momentum, and buy crude oil at $56.20.
- Profit Target is set at prior resistance levels (at $57.40)
- 3x risk-reward means that the stop loss should be placed at $55.90
As we can see in the chart, the final outcome shows that trade momentum gains as crude oil prices continue moving higher with price trendline. This results in profits for the long trade.
Advanced Momentum Trading Techniques: Divergences
Another way traders can use momentum tools is to spot divergences in price action. If price trends are rallying higher, similar movements should also become visible when we view the objective technical readings. When these two elements fail to agree with one another, warning signals should become apparent for traders.
In the example shown above, we can see that asset prices are rallying to reach record highs in the valuation. Of course, this would be an encouraging development for anyone with an open long position. However, any lack of confirmation in the objective technical indicator reading suggests that the current trend is likely vulnerable to reversal. In these cases, it makes sense to collect gains whenever possible and close positions in order to find new opportunities in the market. Of course, this line of thinking applies in both bullish and bearish price trends.
These events are even more concerning when a momentum oscillator actually suggests directional momentum projections that lie in opposition to the dominant price trend. Oscillators like the RSI and CCI can be very useful in this regard. In the example shown above, markets are caught in a clear downtrend. Inexperienced momentum traders might view this price activity as a strong indication to open short positions. However, the technical indicators show signs that bullish momentum is actually beginning to emerge.
As the RSI readings continue to progress in a bullish fashion, markets begin to find support levels before rallying much higher. Traders that were monitoring the asset’s price activity in isolation might have been caught short at very low levels. Of course, this could have resulted in substantial losses quite quickly. However, expert traders watching for signals in the underlying trend momentum may have actually initiated positions in the other direction and collected handsome profits in the trading periods that followed.
Once the initial downtrend is firmly in place, momentum traders should turn to the indicator readings in order to assess whether or not the trend is likely to continue. As the RSI begins to rise, short traders should have looked to close positions and collect any realized profits that were available. Bullish indicator readings make long positions much more attractive in this scenario because market momentum has diverged from the charted price action and projected a reversal higher. As the downside momentum began to stall, triple-bottom support became visible while markets were still trading as relatively inexpensive levels. This gives momentum traders a signal to open contrarian positions and place stop losses just below the aforementioned triple-bottom support zone.
In this case, profit targets should be set to 3x the total level of risk exposure contained in the trade (which would give momentum traders a favorable 3:1 risk-reward ratio). Having these types of trading rule parameters help to ensure that momentum strategies can still be profitable even if half of the positions taken fail to result in gains.
A Successful Approach to Momentum Trading
The examples shown above represent some of the techniques that are employed when investors plan to use momentum strategies in active markets. Once momentum traders are able to identify trend acceleration in an asset’s market price, it’s possible to take a short or long position with the hope that momentum will continue moving in the same direction (either downward or upward). Having strict rule parameters in place can help remove the emotional aspects that can negatively impact trading psychology and create a repeatable framework that can be used for future trades.
When this approach is applied, momentum traders can establish positions based on the underlying strength of the momentum trends in market price. As always, it's important to make sure protective measures are in place for every trade and momentum traders successful will set stop losses that safeguard against unexpected price reversals in any market environment.