Cryptocurrencies notoriously volatile, and to excel in crypto trading would require in-depth strategic planning and technical analysis to secure consistent profits. Among all, momentum trading is used by traders and investors alike to buy an asset with an uptrend price and sell them when the asset’s price starts to lose its momentum.
The strategy reflects the expression as the “trend is your friend” perfectly well. Of course, trading comes with risks but momentum trading gives traders more control and fewer potential failure points.
Today you’ll learn what is momentum trading and the risks it possesses.
What is Momentum Trading?
Momentum trading is a trading style traders use to assess the strength of an asset’s current trend to buy an asset while the price is rising and sell it at an assumed peak price. The rationale behind momentum trading is if there is enough force driving a price move, then it will continue to move in the same direction for a moment.
With the concept of “buy low, sell high” in mind, traders tend to seek advantages from the volatile market for short-term gains through a consistent buy and sell action by following the trend signals.
For example, bitcoin is hovering around $54,000 but generally is in an uptrend price, trader A would place a buy order to catch the wave and take profit at an assumed price of $56,000 before it the wave crashes. Trader A would then repeat the same momentum trading strategy in the hope to catch another wave for the same or other assets.
How Does Momentum Trading Work?
In physics, when an object moves in a particular direction, it continues to do so until an external force interferes in its motion and changes its direction. The same theory applies in trading — an asset tends to move in a specific direction until something triggers the market to react differently.
For example, when a cryptocurrency increases in price, it attracts more attention from both retail and institutional traders. As a result, it pushes the price even higher. Sometimes the uptrend creates a fear of missing out (FOMO) effect, and the price continues to increase for much longer than it would actually do based on Fundamental analysis is an approach used by cryptocurrency investors to establish the intrinsic value of a crypto asset..... The uptrend may continue until a large number of sellers or whales believe that the price is overbought and doesn’t reflect the intrinsic value.
Hence, they open short positions en masse. When the trend reversal happens, and momentum traders exit the market.
However, if the new downtrend is gaining traction, momentum traders may enter the market again. But at this time, they go short. In this way, momentum traders can benefit from both trends with great success.
Key Elements of Momentum Investing
The first task of a momentum trader is to assess a trend’s strength before opening a position. That is to facilitate risk management planning that addresses the market volatility, price fluctuations, and unexpected momentum breaks.
The strategy involves the analysis of three fundamental metrics. These are:
The volume suggests how many traders have opened positions in the direction of the trend in a given period based on the number of assets traded. For example, if the number of assets traded is high, we may assume that the trend is healthy and gaining momentum since there might be many traders involved. Still, sometimes the trading volume can be manipulated by whales. That means financially capable traders can buy or sell large amounts of the asset.
Momentum traders prefer volatile markets to gain from the short-term ups and downs, and cryptocurrencies, including BTC and ETH, are the most suitable asset group. Still, momentum trading involves a precise timing to the opening and closing of a trade.
Finally, momentum trading is closely related to the timeframe selected by a trader since the trend is making sense only within a specific timeframe. For example, Bitcoin price can increase on the hourly chart, but that may be a temporary swing as it declines. If the trend on several timeframes coincides, then this considers as a stronger momentum.
What Are the Characteristics of Momentum Trading?
Before conducting technical and fundamental analysis for momentum trading, traders should know that there are two main approaches to implement momentum trading strategy — relative momentum and absolute momentum.
Relative Momentum Strategy
This strategy refers to the performance comparison of an asset with one another. In which, a trader prefers buying outperforming assets or securities rather than overall underperforming securities.
For example, the hype of NFT emerge in early 2021, and they outperformed Bitcoin and other peers. Relative momentum traders would invest in relevant Decentralized Finance (DeFi) takes the decentralized concept of blockchain and applies it to the world of finance. Build... tokens in such a case.
In April 2021, Bitcoin regained its dominance and rallied to its all-time high of $63,000, while other coins haven’t shown similar returns. In this case, momentum traders would favor Bitcoin due to its stronger momentum.
Absolute Momentum Strategy
It occurs when traders analyze the price of a cryptocurrency or any other asset separately. They compare the current price of the coin with its only past performance.
For example, the Bitcoin price has accelerated and the value increased to over $61,000 suggests that positive momentum is there, and traders would be interested in going long until the trend is reversing.
Best Momentum Indicators
For momentum traders, technical analysis is critical because it helps traders to define the market trend and refine the trading strategies. Once you identify your ideal momentum indicator, it’s fairly easy to determine the market entry and exit points precisely.
Average Directional Index
The average directional index (ADX) is probably the simplest and most popular momentum indicator to determine the strength of a trend. The purpose of ADX is to evaluate momentum for better judgment in an asset.
Basically, ADX is an oscillator, and its calculations are sophisticated but effective for price trend analysis. You should know that it reflects the strength of a price trend on a graph whose line fluctuates between 0 and 100. When the reading dips below 30 suggests that the price is moving sideways. As the ADX breaks above 30, it means that the price is trending. Ultimately, the higher the ADX goes, the stronger is the trend in a particular direction.
However, do note that the ADX doesn’t show whether a trend is bullish or bearish as the indicator is focusing on momentum alone.
Here is how it looks on the chart:
Moving averages (MAs) are the oldest and most common technical indicators out there. They are popular for decades to analyze all kinds of assets, and it’s all for good reasons. Part of the trend indicators group, MAs, cut the price action’s noise to smooth volatility that confuses traders and displays the general trend.
Traders use MA to calculate the average of a cryptocurrency price movement over a given period. For momentum traders, moving averages are important because they can show whether a trend continues its direction or tends to go sideways. It is visually apparent as the MAs follow the price action.
Traders would generally use two MAs with different periods. When the shorter MA crosses the longer MA, then the existing trend may be reversing, and momentum traders would be interested in closing positions.
Relative Strength Index
The relative strength index (RSI) is one of the most popular oscillators, which acts as a momentum indicator. It calculates the size and magnitude of the latest price changes.
The RSI line is plotted on a separated chart below the price action and fluctuates between 0 and 100. If the RSI goes below zero, it shows an oversold level, suggesting that the current downtrend might reverse.
On the flip side, if the RSI goes above 70, the market enters an overbought level, meaning that the current uptrend is losing momentum and might gradually turn into a downtrend or move horizontally. Thus, momentum traders should be on alert whenever the RSI is above 70 or below 30, as the bullish or bearish sentiment is reaching oversaturation, and the trend is changing.
Moving Average Convergence Divergence (MACD) is a bit more sophisticated. It behaves both like momentum and trend-following momentum indicator. The MACD merges two exponential moving averages (EMAs), and its result is calculated by subtracting the 26-period EMA from the 12-period EMA.
However, the two lines displayed on the MACD chart are not the two EMAs used by the indicator. Instead, one of the lines is the MACD line, and another one is the signal line, which can determine changes in price momentum and provide buy or sell signals. There is also a histogram, which represents the difference between the MACD line and the signal line.
When the two lines depart from each other, momentum is considered more substantial, and traders can rest assured that the current trend would continue.
Stochastic is yet another reliable oscillator not only in momentum trading but in swing or day trading too. While it possesses a similar trait and functionality to RSI, it uses an entirely different calculation methodology. In fact, the indicator compares the most recent closing price to the range of its previous prices in a given period.
It is plotted on a separate chart the same as the RSI and fluctuates between zero and 100. Stochastic also displays overbought and oversold levels, but at this time they are considered above 80 and below 20, respectively. This momentum indicator has two lines — the stochastic line, which ranges between the overbought and oversold levels, and the signal line, which can cross the indicator line to anticipate trend reversals.
So, traders would be interested to exit the market when the two lines cross or when the indicator maintains within the overbought or oversold zones.
Commodity Channel Index
The commodity channel index (CCI) is a momentum indicator used to determine a trend’s strength. The indicator calculates the difference between the current price and the historical average price for a given period.
When the CCI is above zero, positioned at the middle of the CCI chart, it indicates that the price is above the historical average.
When the CCI is below zero, then the price is below the average. If the CCI goes higher than 100, it suggests that the price is well above its historical average, and the uptrend is strong.
Stochastics Momentum Index
The Stochastic Momentum Index (SMI) is an improved version of Stochastic, which pays more attention to closing prices. It measures the distance of the current closing price related to the recent high/low range median. It is also used to determine overbought and oversold levels.
Example of Momentum Trading Strategy
There are many momentum strategies that involve several technical indicators or chart patterns to provide buy or sell signals. Perhaps, one of the simplest but still reliable strategies that you can test on your trading platform.
For this, you will need to set an exponential moving average (EMA) with period 19 and the ADX indicator.
Here are the buy conditions:
- Check whether the ADX is at 30 or above — it shows that the price is trending.
- Check whether the EMA is pointing upwards — it suggests an uptrend.
- Wait for a candlestick to close fully above the EMA and enter a long position.
You can exit the market manually when the price crosses EMA. Don’t forget to check the volume from time to time. The higher volume suggests stronger momentum, thus signaling a more accurate indicator to buy.
On the contrary, if you intend to go short with this strategy, you should meet the following conditions:
- Check whether the ADX is at 30 or above – note that the ADX shows the trend’s strength rather than direction.
- Check whether the EMA is pointing downwards – it suggests a bearish trend.
- Enter the market after the first candlestick that closes below the EMA with its full body and shadows.
The Benefits and Limitations of Momentum Trading
This trading style is suitable for beginners because of its simplicity. Above all, momentum trading can be profitable if you caught the momentum at a right time. Besides, it works well in any timeframe and thus, suitable for both day traders and swing traders.
On the flip side, momentum trading can be risky as it purely relies on market information and trends. Traders can be taken by surprise by the unexpected trend reversals. Depending on the securities you’ve chosen, momentum trading is not the best fit for leveraged securities due to the complex underlying futures markets.
Also, prices can fluctuate up and down without any prior signals due to unexpected events or large trades from whales.
Momentum Trading Risks Management
To succeed with momentum trading, you have to apply proper risk management techniques and stick to the strategy you choose.
Here are a few aspects that you should consider:
- Entry point –Make sure to avoid entering the market during overbought and oversold levels. Adjust your entry timing, meaning get into a trade early as soon as you spotted an upward momentum break it breaks.
- Support and resistance – don’t forget to monitor the trend’s support and resistance lines. For instance, if you have long positions and the uptrend is touching its support level, be ready to intervene.
- Position management – make sure to check your positions regularly. It is best to pay attention to the volume and volatility. If the volume declines, it might suggest that traders are losing interest in backing the current trend anymore and are waiting for a reversal.
- Exit point – the exit point is another pivotal moment that can decide the profitability of a trade. Whenever you see clear signs of a trend reversal, make sure to close your positions. Trend reversals might be anticipated by MA crosses and overbought or oversold levels displayed by Stochastic and the RSI indicators.
How to Start Momentum Trading?
You can start momentum trading by following these simple steps:
- Decide on a cryptocurrency you intend to invest in, be it Bitcoin or an altcoin. You can choose the cryptocurrency based on the relative momentum approach, as explained above.
- Build a momentum trading strategy based on the described indicators or use a ready-made one, like the one shared above. The important thing is to stick with it when trading live.
- Test your strategy on a demo account and check it on historical prices on the chart to see whether it provides accurate signals regularly.
- Modify when you feel confident, start trading with live markets by depositing what you can afford to lose.
Make sure to take advantage of the analytical tools and risk management techniques to secure consistent profits.
Is Momentum Trading for you?
All in all, momentum trading is one of those universal strategies that are suitable for both beginners and advanced traders. It works well in any timeframe higher than H30. Thus, it can be implemented by both day traders and swing traders. But the trading results also highly depend on your risk appetite and investment objectives. Ultimately, you should trade with a style that suits you best.
Another major benefit is that momentum trading is backed by a lot of technical indicators that were designed precisely to determine the strength of a trend.