Momentum Trading Strategy

Posted By Darren Winters on May 29, 2020

Momentum Trading Strategy

A momentum trading strategy would have made sizeable profits for traders and investors in the recent crude oil price recovery, which has seen crude oil WTI price rise from $15.06 in late April to $31.9 at the time of writing this piece.

Put another way, momentum trading/investing crude oil, at best entry and exit levels would have yielded a 100% return on capital, and if the trade was leveraged by say 10, those returns would have been 1000%.

But first, what is a momentum trading strategy?

It is when investors buy securities that are rising and sell them when they look to have peaked.

Richard Driehaus was the first investor to use momentum trading as a strategy. His investment philosophy for achieving alpha returns was about “buying high and selling higher”. So momentum trading is about investing with the trend, where the trend is your friend. Momentum trading is the opposite of contrarian trading, where the investors goes against the trend and buys oversold stocks and waits for the market to re-evaluate them higher. 

The goal of momentum trading/investing is to use market volatility by buying opportunities in short-term up-trends and then sell when the securities start to lose momentum

Momentum trading strategy

This momentum trading strategy is repeated, again and again, finding other momentum investing opportunities to outperform the index.

Momentum trading strategy can be illustrated through a metaphor where a body surfer hitches a ride on a wave, then abandons the wave as soon as it loses momentum, only to then go back to the surf and find the next best wave to ride.  

How do investors spot momentum trading opportunities?

Keep a lookout for the “flavor of the day,” when new products, divisions, or concepts capture the market’s imagination, which then forces analysts to readjust their calculations and re-compute profit estimates. Small to medium size technology companies generate an ample supply of these stock opportunities.

Profitable momentum trading is all about timing

Well schooled traders use technical analysis to determine entry and exit points.

What are the best momentum trading indicators?

Momentum traders use the Relative Strength Index (RSI), which is the magnitude of recent price changes to determine overbought or oversold conditions in the price of a stock or other asset. An RSI of 70 or above indicates that the stock has become overbought or overvalued. In other words, momentum trading with an RSI of 70 and above is an indication that the trade is too overcrowded and due for a pullback. 

See six-way to use to the RSI.

The other best momentum trade indicators includes the Rate of Change (ROC), Stochastics, Community Channel Index (CCI), and Moving average convergence/divergence (MACD). 

Profitable momentum trading requires some understanding of technical analysis, which when used in conjunction with the fundamentals can help improve your odds of making profitable trades. 

For more information about momentum trading and other trading, strategies check out the investment home study course.

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