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Momentum Trading System

By June 9, 2020 how to
momentum trading

Momentum trading system involves buying and selling assets (Forex, stocks, indices, etc.) based on the recent force of price trends. The idea is very straight-forward: provided there is sufficient force to push the price move, it will continue to progress in the same direction.

Traders and investors, attracted by the consistent price movement, jump in on the trend in an attempt to generate profit. Thus, the price rises even higher and continues to move up until a large number of sellers enter the market. When the market gets saturated, the momentum switches direction, causing the  price of the asset to lower.

Momentum traders’ (primary goal) is to identify the intensity of the trend in a current direction. They then open a position to capitalise on the (exprected) price change and foresee the perfect time to close the position when it starts to lose its power. The Momentum trading system doesn’t necessarily require investors to find the peak and bottom of a trend. The key objective is to focus on the core, the “body” of the price move. Momentum investors rely on profiting from market sentiment and herding. Herding is a term that describes the phenomenon of traders to follow the majority.

Interested in the history of the Momentum trading system? Follow this link to Momentum Trading Wiki.

Momentum Trading VS Swing Trading

Both Momentum and Swing trading are popular trading strategies. Experienced traders learn to juggle between trading styles and combine them in order to achieve the desired result. Novice traders are encouraged to try different strategies and later master the ones that best suit their personality. 

With Momentum trading, investors direct their efforts at buying into the existing direction and finding the precise time to exit before the trend changes its direction. It is a day trading style, meaning, all trading activities happen within the market’s open hours.

Unlike Momentum trading, Swing trading is a multi day strategy that requires traders to hold their positions open overnight. Swing traders need to practice a lot of patience, as they often need to wait for days or even weeks before the right opportunity to close their trades arises.

Momentum Trading Indicators

Momentum trading indicators are special tools, designed to provide traders with a better understanding of how fast or how much the price of an asset changes. While Momentum trading indicators are great at identifying the timeframe in which price changes are happening, it is best to combine them with other trading indicators to ensure maximum precision and confidence in making the right trading decision.

Best Momentum Indicator

In the plethora of indicators it is impossible to single out one that would carry the title of the best Momentum indicator. Each indicator has a specific purpose and function. 

We’re going to look at the best Momentum indicators, according to the traderXlab most active traders.

1. Moving Average Convergence Divergence (MACD)

The number one on our list of best Momentum indicators is, of course, the Moving Average Convergence Divergence (MACD). The MACD shows the relationship between two moving averages in order to identify a new bullish or bearish trend. 

To interpret the trend direction, use the following rule:

  • When the MACD line crosses ABOVE the zero line, this signals an UPTREND
  • When the MACD line crosses BELOW the zero line, this signals an DOWNTREND

Furthermore, the MACD signals buy or sell orders when one of the two conditions below is true:

  • When the MACD line crosses ABOVE the signal line, traders use this as a BUY indication
  • When the MACD line crosses BELOW the signal line, traders use this as a SELL indication

 2. Relative Strength Index (RSI)

The RSI is the second best Momentum indicator and a popular oscillator that is used as a metric for price changes and the speed at which they change. This Momentum indicator can fluctuate between 0 and 100. 

To interpret the RSI readings, the traders follow these simple rules:

  • If the indicator is showing above 50, the trend is bullish
  • When the Relative Strength Index goes over 70, the asset is potentially overbought.
  • On the contrary, if the RSI is below 50, the momentum is bearish
  • When the Relative Strength Index goes below 30, the asset is potentially oversold.

3. Average Directional Index (ADX)

We have already mentioned the importance of understanding the strength of a trend when utilising the Momentum trading system. The important point of the Average Directional Index is exactly that – it signals if the direction of an asset is gaining or losing strength. Thus, allowing the trader to better calculate their exit points and keep more of the profits.

When working with the ADX, certain rules apply:

  • If ADX is above 30, the trader can trade trends with the strategies of their choice. 
  • If ADX reads below 30, the trader can ignore potential trend trades, as at this point the trends don’t show a strong tendency. 

 All Momentum trading indicators are available on the traderXlab platform.

Famous Momentum Investors

The momentum approach to trading was particularly popular in the pre-WW2 period. The list of famous momentum investors includes Richard Wyckoff, George Seamans, Arnold Bernhard and Robert Rhea. 

Interest in momentum strategies grew even higher in the post-war era. “How I Made $2,000,000 In The Stock Market?” is a book by Nicolas Darvas that became a big-time hit at the time.

Another famous momentum investor was Richard Donchian. Donchian was a commodity advisor, who shared his momentum trading system in a weekly newsletter. His work influenced other legendary momentum investors, among which were Richard Dennis, Michael Marcus, David Druz and Ed Seykota.

Summary

Momentum trading system has been widely used and admired since the pre-WWII period, with a large number of famous momentum investors, namely Ed Seykota, Robert Rhea, Richard Wyckoff and many others. While Momentum trading vs Swing trading are entirely different trading techniques, both however require a great deal of patience and discipline. The best Momentum indicators include the Moving Average Convergence Divergence (MACD), the Relative Strength Index (RSI) and the Average Directional Index (ADX).

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