What is a momentum strategy?
Momentum strategy relies on making a profit by going long or short when price movements of an asset show a strong trend in an upwards or a downwards direction i.e. when there is a high price momentum either way. If an asset, such as stock or ETF, is undergoing an upward trend (so increasing in price), momentum trader would go long in it (i.e. buy it), out of expectation that this upward trend will persist over some time. If an asset is facing a downward trend, so decreasing in price, the strategy then suggests going short in this asset as the price is expected to continue to decline. In simple words, this strategy relies on the continuation of a price trend in the future, and profits are made by staying on this trend just until it ends and the time frames may be quite different depending on each case. In general, momentum strategy is typically implemented in short-term trading as it mostly relies on short-term price volatilities.
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This strategy relies heavily on technical analysis of short-term price shifts and is the opposite of fundamental investing. It is not concerned with the actual financial or operational performance of a company, but rather on temporary price volatilities of an asset, relying heavily on the behavior of other traders on the market. In case this strategy is used for very short-term trading, market sentiment is key: when a financial instrument increases in price, it starts drawing more attention from investors and traders who now try to get in before the price rises even higher. This sudden wave of demand itself pushes the price up further for some time. Once the demand is satisifed and/or sellers who trade in the opposite direction start entering the market, the price momentum may change the direction and cause the price to decrease; momentum traders try to make a profit before such situation happens, constantly exploiting the sentiments of the market.
The strength of a price momentum and the trading process depends on a few things:
- Volume. The amount of a financial instrument traded directly influences your ability to enter and exit positions quickly, which is vital in short-term momentum trading. A liquid market with a big volume of an asset traded constantly allows you to do so.
- Volatility. Volatile markets and instruments provide you with the opportunity to take advantage of short-term price increases and decreases.
- Time period. Momentum strategies are usually traded in the short-term and the duration of your position depends directly on the time for which a trend lasts.
How to implement momentum strategy on eToro?
The few simple general steps for this strategy:
- Choose an asset which you are going to trade, for example a stock of a particular company.
- Use the tools of technical analysis available on eToro to spot an upward or a downward trend, and identify the time you should enter the trade.
- Take a position as the price trend of your asset gains momentum, in the direction of this trend: long position for an uptrend and a short position for a downtrend.
- When the trend starts to show signals of weaking, for example when the price trend and the momentum indicators start to diverge, exit a position, hopefully making a profit along the way, before the trend reverses and you start losing money on the trade.
Let’s look at the process in more detail.
Technical tools in momentum trading
As you hopefully realized, the entire strategy relies heavily on a trader’s ability to spot the right time to enter and exit a trade and such points are usually identified using the tools of technical analysis. How can we use it then? There are quite a few tools available on eToro.
Trend lines are of course the most straightforward way to identify price momentum; an upward trend line would indicate a positive price trend and a downward trend line would indicate a downward direction. Many times this involves using a moving average (MA) indicator to spot the right trading signals. This is quite a useful indicator that helps you to spot an overall dominating trend and at the same time tone down short-term insignificant price fluctuations, sometimes called ‘noise’. Now, in case the price of an asset remains above the moving average indicator or at it, that could imply an upward price trend. On the chart of Dow-Jones index below you can see the price staying above the moving average for quite a substantial time period, with a corresponding upward price trend, until the chart crosses the MA line and begins to decrease. This time frame is quite large however, but is a good example to understand the concept.
The opposite is true for a situation when a price keeps moving below the moving average, indicating a possible downward trend.
Stochastic oscillator is another commonly used tool in momentum strategy. It is an indicator that compares the closing price of an asset to prices for a specific time period. A positive trend can be implied when the closing price of the asset is at or near the high level of the price range over the chosen time period. On the other hand, when the closing price is near the low level this could imply a downward price trend. Because stochaistic indicator usually takes a value between 0 and 100, a value of 50 and more may be a sign of a positive trend gaining momentum, and values below 50 signal a downtrend, likewise. Beware that extreme end values (so below 20 and above 80) may indicate oversold and overbought conditions leading to a price reversal. eToro allows you to customize the levels of both Stochaistics and the Stochaistic Momentum indicators to your own technical analysis techniques, like shown on the image below.
This indicator could be used to spot opportunities to exit and enter positions, but many traders also interpret it as a confirmation of a price action. In simple terms, if the line of the indicator currently below the zero line is crossing it into an upwards direction it could be a sign of a positive price momentum beginning, while a crossing from above and onto a downwards direction may show a decreasing price momentum, like shown on the image below.
Relative Strength Index (RSI) is another momentum indicator which is good at signalling buy and sell conditions, with values between 0 and 100 (which again could be customized to your own preferences). Just like stochaistic indicators, it can be used to spot overbought and oversold conditions. Momentum strategy then relies on the concept of retracements between these varying price levels that could be good indications of strong price trends in one direction or another. Do rememeber however, that just because RSI may identify signals of overbought and oversold periods it doesn’t necessarily mean the trend will change (i.e. reverse) as the price may remain in the overbought or oversold areas for quite some time. Because of this problem you may consider using RSI in combination with other indicators.
Risks of a momentum strategy
Of course, like any other strategy, momentum strategy involves risks. It is very important to choose the right time to exit in momentum trading. As you can see from the examples above, trends change very fast and a trade becomes riskier the longer you stay in a position (although that does depend on the timeframe you are trading in). That is also one of the reasons this strategy is mostly used in day trading. Momentum strategy is very volatile and can lead to a loss as easily as to a profit, it not implemented correctly. Don’t forget to set your stop-loss levels correctly in case the situation turns against your expectation; for instance, you could consider setting your stop-loss just below the level indicating first signs of a price trend changing.
As you have hopefully seen, momentum strategy is one of the most popular short-term trading strategies which relies heavily on the tools of the technical analysis.This strategy is quite risky and depends highly on volatility, so it could be a good idea to practice on a demo account before placing your own money at stake. As you know, the majority of beginner day traders that do not learn the basics, practice enough or analyze their performance do end up losing money. Remember that trading involves capital loss risks and enjoy using the eToro platform! Best of luck.
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