What is momentum trading? And how does it work?

For the purpose of this article momentum refers to the rate of acceleration of a security’s price ie how quickly it builds up speed in terms of price. Healthy price trends tend to display strong momentum while weakening price trends often have decreasing momentum.

Momentum trading aims to identify explosive share price moves for the purpose of capturing profits. When a momentum trader observes acceleration in a share’s price the trader will take a position in the direction of the movement (long or short) in the hope that the momentum will continue in either the upward or downward trend.

Technical Indicators are commonly used to forecast future movements through the study of past prices in the market. There are a large number of indicators that can be used when measuring momentum. This article will be limited to the Relative Strength Index (RSI).

RSI is one of the easiest indicators to incorporate into a trading strategy and is calculated using the formula below:

RSI = 100 – [100 /(1 + RS)]

RS = Average of n periods close up / Average of n periods close down

Most traders will experiment with the number of periods used to determine the measure best suited to your trading strategy.   However J Wilder the inventor of RSI suggests 14 as the default.

Momentum indicators especially RSI are useful in identifying market extremes such as over bought or oversold levels. The reasoning is that rapid price increases are not sustainable and will always result in a pull back or correction. Momentum is designed to capture this.

This may seem complicated. However, in short, RSI is an oscillator that ranges between 0 and 100.

Typically a share is considered overbought once the RSI exceeds 70. Similarly a share is considered oversold when the RSI is below 30. As rapid price increases are not always sustainable and can result in a reversal i.e. a share is overbought (over 70) this can be identified as a sell signal, likewise a share oversold (below 30) can be seen as a sell signal. Traders can also widen these parameters from 30 – 70 to say 25 – 75 to confirm their buy or sell triggers.

Using the RSI in isolation can result in inaccurate signals and therefore many traders will apply several indicators together to increase their accuracy. Other indicators used include but are not limited to exponential moving averages, MACDs, Bollinger bands, Stochastic & Rate of change. However these are beyond the scope of this article . Please note momentum trading can be utilized by any trader. However, extensive back testing or paper trading is suggested before attempting any strategies.

Incorporating stop loss orders are highly recommended when attempting to capture momentum.