Momentum trading is a strategy that aims to profit from short-term and intermediate-term trends in the markets. By identifying periods of price acceleration and deceleration, momentum traders look to enter trades in the direction of the prevailing trend. Let’s examine some of the key aspects of this approach.
Identifying the Trend
Momentum traders rely heavily on technical indicators to gauge the strength or weakness of a trend. Simple moving averages are popular for trend identification, with gaps between the short and long SMA indicating momentum. Rate of change (ROC) and moving average convergence divergence (MACD) also help validate trends. Daily or weekly charts are ideal timeframes.
Entry Signals
Traders look to enter long when securities close above short-term averages or resistance levels. For shorts, the criteria is a close below support. Key breakdowns and breakouts signal potential for larger moves. Wait for retracements against the trend for lower-risk entries rather than chasing moves.
Managing Positions
Positions are added to on dips and pulls if the broader trend remains intact. Profit targets are set at prior resistance points. Stops are tightened as profits accrue. Partial closes of winning trades lower risk. Losing trades are closed quickly if indicators show momentum shifts.
Backtesting for Optimization
Proper backtesting on historical data helps determine the most reliable entry and exit parameters, as well as ideal asset class/instrument combinations. Factors like optimal lookback periods for indicators, volatility filters and position sizing need testing. This establishes statistical edge and realistic performance metrics.
Risk Management
Strict risk controls like maximum 2% position size and hard stops are mandatory given trends can reverse abruptly. Leverage should be limited. Diversification across uncorrelated assets reduces drawdown risk. Discipline and patience are key as momentum strategies are trend-following in nature.
In summary, momentum trading succeeds by identifying markets with demonstrated persistence in short-term price trends and timing entries and exits effectively using technical momentum indicators on the selected higher probability setups. Solid strategy testing, risk practices and discipline are essential.