Momentum Trading Strategies

Over the last few decades, momentum trading has become extremely popular as one of the financial markets’ go-to strategies. What is momentum trading, though? Momentum trading strategies are based on the idea that assets that have performed strongly on the markets for 3 to 12 months will continue to do so, while those that have performed poorly are likely to resume declining.

These price movement trends are exactly what momentum traders capitalize on by buying assets with rising market prices and selling those with falling prices. This is done to ride the price momentum and generate profits.

Key Takeaways

Momentum trading strategies are based on the concept that if there is enough force behind an asset’s price direction, it will continue moving in that direction.

Traders utilizing this strategy buy assets with rising prices and sell those with falling prices (serving as the opposite of what is reversal trading).

The goal of this strategy is to ride the price momentum and generate profits.

Want to learn everything you need about these Trading Strategies? Keep on reading!

The origins of momentum trading

The momentum strategy has been all the rage over the last 3 decades. How did it get to be this way though?

Richard Driehaus is generally hailed as the Father of Momentum Investing

Although Richard Driehaus, a pioneering investor and businessman, popularized and successfully applied momentum trading during the 1980s to the extent that he is regarded as the “Father of Momentum Investing”, the origins of the momentum strategy stretch as far back as the Victorian era.

Momentum trading in the Victorian era

Despite having much less sophisticated technical analysis indicators, platforms, and technology than present day traders, trading records from the London Stock Exchange prove that Victorian traders persistently generated significant return (or profit) in the 19th century. What is more, this was no accident.

In 1866, Overend, Gurney and Company, a London-based bank that provided loans and conducted large transactions with other banks and businesses, collapsed. The bank’s failure caused international financial panic which became known as the Panic of 1866. As any good trader knows however: where there is high volatility, there is also opportunity for large profits (a philosophy that also forms the basis of what is volatility trading). And just like that, the momentum strategy broke into the mainstream more than a century before Driehaus popularized it!

Richard Donchian

Nevertheless, there is one other important figure in the history of the Momentum strategy that once again proceeds Driehaus: Richard Donchian, the “Father of Trend Following”. More than 30 years prior to Driehaus’ work, Donchian developed his Trend Following strategy. Donchian’s set of rules was based on his theory that traders should buy assets when their price goes up, and sell them when they go down, as their price trends are expected to continue. Sound familiar?

Today, momentum traders often use the Donchian Channel, an indicator developed by Donchian, to identify potential buy and sell signals based on breakouts and price momentum.

How to momentum trade

Following in the footsteps of Donchian and Dreihaus, modern traders who use momentum as part of their strategy believe that when a stock is going up, it will continue to go up and vice versa. If you are interested in using these strategies effectively on our platform, you need to also keep an eye out for high-impact news that might significantly propel or hinder your chosen financial instrument’s momentum. Also, it is important to understand that the momentum strategy involves a good deal of risk. Hence, applying stop orders is a valuable practice to minimize potential losses.

The most important step of all for a Momentum Trader however, is focusing on trends seen in a stock’s trading volume, earnings, and price. To do this, you need to arm yourself with the right set of analytical indicators to identify potential momentum stocks – assets which have demonstrated recent trends of strong financial performance.

Wondering which indicators are your best friends for trading with a momentum strategy? Learn about them below!

1. The momentum indicator

The Momentum Indicator plays the most essential role for Momentum Traders. The reason is that this indicator helps a traders identify the strength of market trends before making investment decisions. As a technical analysis indicator, it works by comparing the latest price to a previous price over a specified period. A rising momentum suggests the upward trend may have enough power to continue, signalling a buy and vice versa. Using this strategy, traders can spot potential trend reversals, identify overbought or oversold conditions, or confirm the strength of a particular trend, thus assisting in decision-making and what is risk management in trading.

Momentum indicators directly measure the speed or velocity of price changes in a particular instrument, showing the rate of rise or fall in prices, which is the concept at the heart of this strategy.

2. Moving averages

The second most important indicator when momentum trading is the Moving Averages one. While moving averages simply show price trends, momentum indicators measure the rate of price change, crucial for predicting future movements.

Nevertheless, moving averages still help traders identify potential buy and sell signals by showing if a stock's price is trending up or down over a set period of time, making it a valuable aspect of a shares trading strategy. Moving averages help smooth out price data by creating a constantly updated average price, providing a clearer picture of the overall price movement direction. This can be especially useful in a momentum strategy, where identifying the direction and strength of a trend is essential.

3. Moving average convergence divergence (MACD)

Though the Moving Averages may hold a higher rank in Momentum Trading, underestimating the impact of the MACD (Moving Average Convergence Divergence) indicator would be a mistake. The MACD, a powerful and versatile indicator, acts as a secondary confirmation of the momentum perceived through Moving Averages. It provides valuable signals about possible reversals, overbought or oversold conditions, and divergences between price and momentum. Although the MACD is very useful, it is derivative and less directly indicative of price momentum.

Utilizing both the MACD and Moving Averages together can lead a trader to broader, more comprehensive market analysis.

Momentum day trading

As momentum and Day Trading are both short-term trading strategies, they are often used together. When using the momentum day trading strategy (buying and selling a financial instrument within one single trading day), traders will exploit fluctuations in a stock's momentum to garner profits. This is exactly why the momentum trading strategies are a perfect fit for day trading: they both concentrate on the speed of movement in assets to anticipate future trends.

You’ll be surprised to learn that this strategy has a decidedly non-trading origin: it is actually based on Newton's First Law of Motion! Newton claimed that an object will remain at rest or move in a straight line at a constant speed unless it is acted upon by an external force. In the same way, an asset with a price movement will likely continue in its direction until a significant force stops it.

Traders look for financial instruments with a significant volume increase for their trading account and will then observe their acceleration to decide whether to buy or sell. Momentum indicators like the Relative strength index (RSI), Moving average convergence divergence (MACD), or Stochastic Oscillator will help traders identify when a stock is overbought or oversold.

Momentum day trading strategies

So, which momentum strategies should a trader use when day trading? There are two commonly used strategies that are used when day trading. Let’s break them down:

1. The Trend Following strategy involves identifying securities with a strong directional momentum - either upward or downward - and using a platform to take positions aligned with that momentum. This strategy relies on the assumption that the price direction will persist for the trading day.

2. Scalping involves making several small trades to leverage tiny price gaps often brought about by bid-ask spreads or market imbalances. Scalpers aim to be in and out of a trade quickly, capitalizing on swift price movements.

Both these strategies require a trader’s eagle-eyed attention to market trends and precise timing. While Trend Following is ideal for those who prefer analyzing market trends over a period of time, Scalping is for those who want quick, small profits.

Given that Day Trading is limited to one single trading day, the Scalping strategy is more fitting for day trading strategies. Trend Following, by nature, requires patience and a long-term perspective as traders attempt to capitalize on large market movements. Momentum day trading, on the other hand, revolves around swift decision-making based on short-term price fluctuations. The delayed response inherent in the Trend Following strategy can often cause a significant lag in recognizing and reacting to momentum shifts, making it potentially unsuitable and less profitable for traders who wish to take part in momentum day trading.

Momentum trading CFDs

Momentum day traders will find their niche within the dynamic and fast changing realm of CFD Trading, as the market attracts investors and hedge funds that thrive on swift market shifts and seek accelerated gains.

The leveraged nature of Contracts for Difference (CFDs) amplifies price movements. With the ability to speculate on both rising and falling markets through their trading account, CFDs enable day traders to ride prevailing trends for short-term profits on the trading platform of their choice. This fast-paced environment, coupled with the ease of entry and exit, further intensifies momentum as CFD traders swiftly respond to market shifts. As a result, the CFD market becomes a hotbed for momentum trading strategies, enticing both seasoned and novice traders to harness its energetic potential for financial success.

CFD retail traders often employ simple momentum indicators on their trading account, platform, and as part of their strategy, such as Moving Averages and Relative Strength Index (RSI), to make informed entry and exit decisions. Conversely, hedge funds, armed with sophisticated algorithmic models and real-time data feeds, delve into more intricate strategies, incorporating factors like volume trading (What is volume trading? The amount of an instrument that was traded during a given time period) and market sentiment to enhance their edge.

Momentum trading forex

In the world of CFD trading, forex currency pairs reign as the preferred and most frequently traded financial instrument, enabling CFD traders to capitalize on price movements without the need for actual currency ownership. In the CFD forex market, a common thread unites diverse players - retail traders, institutional investors, banks, and multinational corporations - each with a distinct motive, method, and CFD forex trading strategy:

Retail traders aim to earn quick profits by tracking short-term trends in the market with indicators such as moving averages, chart patterns, and trading platforms, so they can act quickly.
Institutional investors (a large organization like a pension fund or an insurance company that invests money on behalf of others to grow their savings) wish to optimize their investments, carefully managing the balance between potential rewards and risks.
Banks intend to boost profits and enhance the stability of the financial system, contributing to the well-being of the entire market. Indicators like algorithmic trading systems (proprietary, automated trading, high-frequency trading (HFT) platforms) and real-time data analysis.
Multinational corporations intend to manage currency fluctuations by employing a momentum strategy that aids them in making well-informed decisions and refining their international trade operations. They rely on indicators like real-time exchange rate monitoring, trend analysis software, and macroeconomic data interpretation.

Momentum trading stocks

Momentum trading forex CFDs is more popular than trading stock CFDs as there is higher complexity and greater volatility often associated with individual stocks compared to currency pairs. A momentum forex CFD day trader will capitalise on fast changes in currency values, while a momentum stock CFD trader will speculate on quick shifts in price movements of individual company stock prices, an inherently riskier endeavour.

Nevertheless, momentum trading stock CFDs can offer benefits such as the potential to profit from company-specific events and earnings reports. Stock CFDs also allow traders to tap into diverse industries and sectors on their platform, potentially yielding unique opportunities not present in the forex market. This versatility can enhance a trader's ability to capture short-term gains across a wide range of market dynamics, setting stock CFDs apart from forex CFDs in terms of opportunities.

Momentum trading crypto

Another increasingly popular market for momentum trading CFDs is the crypto market. Despite the lower market maturity and regulatory uncertainties surrounding cryptocurrencies, with its explosive growth, potential for substantial profits, and high volatility, the rapid price fluctuations and strong trends exhibited by cryptocurrencies have made momentum trading crypto CFDs a popular strategy among day traders seeking quick and significant gains.

Despite the comparatively lesser popularity of trading crypto CFDs when compared to stock CFDs, different types of traders adopt a variety of Technical indicators in their CFD Crypto trading strategy:

Day traders use real-time charts, order flow data, and candlestick patterns for quick decisions on short-lived price spikes.
Swing traders rely on indicators like moving averages, MACD, and Fibonacci retracements for medium-term trend reversal identification.
Speculators use indicators like Bollinger Bands in their trading Strategy and Stochastic Oscillators to assess potential price fluctuations driven by market volatility.
Experienced cryptocurrency investors combine market sentiment indicators and news analysis with their insights for navigating momentum shifts.
Risk-tolerant investors use indicators like ATR and RSI to set risk-appropriate entry and exit points during optimistic market periods.
Leverage users employ trailing stops and pivot points to enhance exposure during significant momentum swings.

Are the Momentum Trading Strategies for you?

The Trend Following and Scalping strategies may be fit for certain Retail CFD clients.

Trend Following, which entails purchasing assets when they show upward trends and selling when trends look downwards, can be suitable for you when there are clear, sustained price trends in the market. This strategy banks on the concept that “the trend is your friend”, meaning beneficial trades generally align with the current trend - buy for an upward trend, sell for a downward. Successfully employing this strategy on a platform requires patience from a trader, as trends may take weeks or months to develop, and a disciplined approach to stick with the trend despite minor fluctuations. Clients can seize opportunities in long-term, upward or downward trend movements across various asset classes, from stocks to commodities. Overall, if a client can afford to hold positions for an extended period and accept the risks involved, Trend Following can be a viable strategy.

Meanwhile, the Scalping strategy can be a good fit for you if you have the ability to keep a constant eye on market fluctuations due to the strategy’s fast pace and numerous quick transactions. Scalping is a high-speed, high-volume strategy that depends on small profit margins from brief trades, so it would demand considerable attention and time from you. It exploits the inherent volatility of the market and aims to help you benefit from minuscule price changes. Yet, it requires technical analysis skills, the use of indicators, a good platform and swift decision-making from a trader. So, while the Scalping strategy offers the potential for quick returns, it also exposes CFD traders to high risk. Essentially, whether Scalping is a suitable strategy for you or not highly depends on your risk appetite, market knowledge, resources, and time commitment.

Both strategies can offer gains, but their viability relies heavily on a trader’s knowledge level, risk tolerance, time commitment and comfort with decision-making in erratic markets.

Momentum Trading Strategies - Pros

Momentum Trading Strategies boast various advantages, making them go-to strategies for many traders.

The Trend Following Strategy – Pros

In particular, the Trend Following strategy opens a world of opportunities for CFD retail traders, bringing a basket of benefits to the table:

Solid Track Record: Backed by historical success and trends, traders can make more informed decisions, avoiding knee-jerk reactions with a tried-and-true strategy that helps traders navigate the CFD landscape from their chosen platform.
Diverse Market Suitability: Trend Following works across a diverse number of assets and financial markets, such as shares, commodities, and forex, accommodating traders with different preferences.
Sensible Risk Management: Clear rules and stop-loss mechanisms protect traders from sudden market downturns.
Logic over Emotion: Rule-based strategies like Trend Following minimize the opening and closing of positions based on emotions, ensuring discipline and rational decision-making.

The Scalping Strategy – Pros

On the other hand, the scalping strategy, characterized by quick and frequent trades on a platform, can provide benefits that the lengthier Trend Following strategy cannot, including:

Opportunity for Rapid Profits: The Scalping strategy takes advantage of short-term price shifts, enabling traders to seize quick gains within mere minutes.
Lessened Risk Exposure: Short trading periods minimize the dangers linked to overnight market shifts, protecting traders from unforeseen downward turns.
Heightened Precision: Scalpers concentrate on minor price fluctuations, demanding a sharp focus on technical analysis and indicators, which helps refine their expertise.
Expanded Prospects: The frequent trading frequency opens doors to numerous opportunities for profitable entries, particularly in markets prone to volatility.
Diminished Market Exposure: Spending limited time in the market lessens susceptibility to significant news events or prolonged trends, ultimately reducing the potential for losses.

Momentum Trading Strategies - Cons

Nevertheless, although these strategies have gained popularity over the years due to their potential for high returns, there are also some downsides to this approach.

The Trend following strategy – Cons

While the Trend Following strategy may seem attractive for Retail CFD traders due to its simplistic approach and potential for significant gains, it comes with its own drawbacks.

Misinterpreted Trends: The Trend Following strategy is heavily reliant on identifiable trends, which don't always present clearly in markets. Because of this, traders can sometimes misinterpret trends and end up with false signals, leading to potentially damaging losses. Perceived trends may not be as they appear and can result in traders entering or exiting a trade based on what they perceive to be trends which end up abruptly reversing course.
Potential for Drawdowns: If a trend is misinterpreted, this strategy could result in consecutive losses — or drawdowns.
Lagging Indicator: The Trend Following strategy is considered a lagging indicator, as it follows price movements and signals a trend only after it has already been established. This very nature of the strategy means the signaling of delayed entry points.

Scalping – Cons

Similarly, the Scalping strategy also has its own set of setbacks:

Intensity: The Scalping strategy demands constant, active monitoring of minor market shifts. It's not a set-it-and-forget-it strategy.
Stressful: Frequent buying and selling requires continuous focus which can be stressful during unstable market conditions.
Time-consuming: Successful Scalping demands significant time which could be demanding for part-time traders.
Risks of Emotional Trading: The need for quick decision-making increases the risk of emotional trading, potentially leading to sizable losses.

Let’s sum up!

So, what’s the verdict? Strategies like Scalping and Trend Following that rely on momentum can be a handy option for retail traders in the CFD market. They make use of handy analytical indicators like Moving Averages, MACD, and momentum indicators on their platform to look for stocks that are picking up steam and to track how fast prices are changing.

Trend Following can be a great fit if you're comfortable hanging onto positions for much longer periods, and can ride along with the current trends of the market. On the flip side, the Scalping strategy might be your cup of tea if you're looking for quicker returns and you're able to keep an eye on the market's every move.

Both these strategies can get you good returns, but their success is tied to your knowledge, the amount of time you can devote, your platform, and each strategy’s compatibility with your strategies and needs. Also, always remember, using stop orders can help you keep your losses in check with these strategies.

Happy momentum trading!