What Is Momentum Trading? Profiting from Market Volatility
Key Questions Answered
- Momentum traders use market volatility to their advantage and mainly focus on short-term price movements.
- Although momentum trading is usually associated with short-term strategies such as day trading or scalping, it may also apply to longer-term hodlers if the trend continues over a prolonged period.
- Momentum traders use technical indicators such as moving averages, MACD, RSI, support and resistance levels, and Candlestick Patterns to predict market trends.
Momentum trading is a strategy that can be applied both to the traditional stock market and to cryptocurrencies. In both contexts, the term “momentum” means as much as “underlying trend strength.”
Momentum traders use market volatility to their advantage and mainly focus on short-term price movements. They buy assets when they detect a beginning uptrend, and sell coins or tokens at the highest point before the price falls again. In other words, momentum traders follow the idea “buy high, sell even higher.”
The momentum trading strategy suggests that an asset’s upward or downward trend continues once it has gained traction. This idea was established by the physicist Isaac Newton, who discovered that moving objects usually remain in motion unless disrupted by an external factor.
What is Momentum trading?
There are two main subcategories of momentum trading: absolute and relative.
- In absolute momentum trading, the trader considers just one asset, such as Bitcoin, and analyzes its past price movements to predict future trends.
- In relative momentum trading, the trader compares different coins or tokens. For example, a trader may analyze Bitcoin’s and Ethereum‘s price performances. In this case, whichever price history seems more promising is chosen over the other.
How Does Momentum Trading Differ from Long-term HODLING?
One of the main differences between momentum trading and long-term investment is the time frame a trader hodls a coin to make a profit. Momentum traders buy and sell assets frequently. They are constantly on the lookout for new uptrends and lucrative buying opportunities. Therefore, momentum trading is a very active trading style for which traders use technical analysis techniques.
On the other hand, long-term investors usually select coins with the potential to gain in value over time and often hodl it for an extensive period. This approach is more passive, as many buyers may invest without thinking much about their assets, hoping for an increase in value over time.
Although momentum trading is usually associated with short-term strategies such as day trading or scalping, it may also apply to longer-term hodlers if the trend continues over a prolonged period. While market volatility is discomforting for many long-term investors, it is what momentum traders rely on to make a profit. Finally, one’s unique trading style depends on several factors such as personality type, risk tolerance, and personal preferences.
How Does Momentum Trading Work?
Momentum traders mainly rely on technical analysis, statistical probabilities of past price movements, and indications for future rises and falls in value. Therefore, momentum trading does not take into account information regarding the asset’s use-case, politics, or the world economy, which could affect the price. Instead, the following factors generally play an essential role in momentum trading:
- Market volatility: As mentioned earlier, momentum trading relies on the size of price swings, especially on short-time rises and falls in price. It is, therefore, one of the most critical factors to consider when using this strategy. As momentum trading works best in volatile market environments, the highly volatile crypto market is more suitable for this strategy than the traditional stock market.
- Volume: This factor represents a specific coin’s 24-hour market activity i.e., the number of coins that have been traded within 24 hours. A high volume indicates sufficient supply and demand for a substantial price movement. However, traders need to remember that the volume can be manipulated by whales selling or buying large amounts of assets at once. These traders own an enormous amount of cryptocurrency, giving them the power to drive the price up or down merely by entering or exiting the market.
- Time frames: Momentum traders analyze price movements within different periods, such as daily, hourly, and 15-minute charts. For example, if they detect the same uptrend in several of these charts, the momentum is considered significant. On the other hand, when the price increase is merely visible within one specific time frame, it may be part of an ongoing downtrend, and therefore less significant.
What Kinds of Technical Indicators Do Momentum Traders Use?
Many technical indicators can prove helpful in momentum trading. Among the most popular is the moving average. Essentially, a trader can detect a forming trend and a strong momentum by analyzing the moving average. The MACD indicator (moving average convergence divergence) is one of the most frequently used tools for detecting not only price momentum but also potential trend reversals.
Support and Resistance levels
Additionally, momentum traders analyze support and resistance levels to detect potential trend pauses and reversals. The support level on a price chart lies where traders expect a halt or reversal in a downtrend due to a concentration of demand. Conversely, resistance occurs when a concentration of supply causes an uptrend to pause temporarily. Once the price breaks through one of these barriers, the price movement becomes more volatile and gains traction.
Figure 1: Support and resistance levels (Source: Phemex Academy)
Momentum traders may also pay attention to candlestick patterns formed by price action on the charts. These formations can be bullish or bearish, which means they predict an uptrend or downtrend in price. Various formations are illustrated below, and you can read about more of them on the complete guide to the most important candlestick patterns.
Figure 2: The Piercing Line candlestick pattern indicating an uptrend (source: Phemex Academy)
Figure 3: The Hanging Man candlestick pattern indicating a bear market (source: Phemex Academy)
Figure 4: The Bearish Engulfing candlestick pattern indicating a downtrend (source: Phemex Academy)
The Relative Strength Index
The Relative Strength Index, widely known as RSI, is another valuable tool for predicting future price movements. When the RSI exceeds 70, an asset is considered overbought, which indicates that the asset’s price is likely to decrease. Conversely, an RSI of below 30 indicates that the asset is oversold, so a price increase is expected.
Although technical analysis can be helpful to predict market trends, its indicators should never be interpreted in isolation. For example, a trader should never focus on candlestick patterns alone, as they can be easily misinterpreted, especially by inexperienced traders.
What Are the Pros and Cons of Momentum Trading?
Pro: Momentum trading can be profitable
Momentum trading can be very profitable. Due to the crypto market’s high volatility, this strategy works exceptionally well with digital assets. Momentum traders often gain considerably higher profits in a shorter amount of time than long-term traders. Additionally, employing technical analysis to predict price movements is an excellent way to not only make quick profits in a bull market but also to predict forming downtrends. In such a case, it may be preferable to protect your asset from a substantial price decrease by buying a stablecoin instead.
Con #1: Assets are more likely to lose value
On the other hand, this potential for quick profit gains also means your assets are more likely to lose value just as fast. And depending on the frequency a momentum trader buys and sells assets, trading fees may also be a disadvantage of this strategy. These fees can add up quickly, especially when trading bots are used.
Con #2: Trend reversals may occur
Moreover, past success is no guarantee for future price movements. A trend could always reverse without indications, and studies supposedly proving the superiority of momentum trading over long-term investments may be unreliable. They do not apply to all trading scenarios because the strategy’s success depends on the market environment. For example, while momentum trading works great in a bull market, it can be misleading and cause severe losses in bear and bull traps. In these scenarios, all technical indicators point a certain way while the price moves in the opposite direction.
Should I Engage in Momentum Trading?
Momentum trading is not for everyone. To be successful with this trading style, you need to have the technical knowledge and enough practice analyzing the market. Having the right personality type is also essential. If you feel easily stressed by the market’s volatile movements, and tend to make rash decisions and engage in FOMO, the lower-risk approach of long-term investing might be more suitable for you.
In addition, you should be aware that any type of short-term trading requires constant research and engagement with the market. You need to be able to enter and exit at just the right time to maximize your profits and avoid unnecessary losses. If you cannot or are not willing to invest a good portion of your day into trading cryptocurrencies, then again, long-term investment would be the better option for you.
Momentum trading can help traders make an immense profit in a relatively short amount of time. However, it is essential to have a working knowledge of technical analysis and specific indicators of a forming uptrend or a downtrend. The speed at which you can make a profit using the momentum trading strategy is the same speed at which your assets can decrease in value. Depending on your personality type and preferences, long-term investment may be more suitable for you than momentum trading.
Lastly, traders need not limit themselves to a single strategy. Once you have sufficient knowledge about technical analysis, you can combine different methods and find your own unique trading style.