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Understanding Momentum Trading: A Complete Guide

Learn what momentum trading is, how to implement momentum strategies, and why it's an effective trading approach in financial markets.

What is Momentum?

Momentum tracks the velocity of a stock price, specifically the rate of change of an asset's price. Trading with momentum requires understanding its sine wave nature and its close relationship with volatility. This knowledge helps determine whether to take long or short positions.

There are two types of momentum used in trading strategies:

  1. Absolute Momentum: An asset's momentum compared to its peers (same industry or sector)
  2. Relative Momentum: An asset's momentum compared to its own historical momentum (e.g., past 1 year)

Momentum can have both positive and negative values:

  • Negative Momentum (-M): Asset price has been decreasing
  • Positive Momentum (+M): Asset price has been increasing

Basic Momentum Calculation

The simplest method to calculate momentum is:

Momentum = ((Current Price - Price X days ago) / Price X days ago) × 100

How to Use Momentum for Trading

Momentum trading revolves around selling losers and buying winners. This investment strategy is purely technical and assumes observed trends will continue. Here are the four key aspects to consider:

1. Stock Selection

  • ✅ Trade with liquid and volatile assets (stocks preferred over ETFs/Bonds)
  • ✅ Focus on popular stocks to leverage emotional/irrational traders
  • ❌ Avoid leveraged and inverse products

2. Timing Entry/Exit

  • ✅ Wait for confirmed trends before entering
  • ❌ Be cautious of momentum trend reversals
  • ❌ Don't try to anticipate trend reversals; cut losses early

3. Position Sizing

Adjust position sizes based on market conditions:

Bull Market:

  • Long → Larger positions
  • Short → Smaller positions

Bear Market:

  • Long → Smaller positions
  • Short → Larger positions

4. Momentum-Volatility Relationship

Optimal trading conditions:

Long Positions:

  • ⬆️ Positive momentum
  • ⬇️ Decreasing volatility

Short Positions:

  • ⬇️ Negative momentum
  • ⬆️ Increasing volatility
  • VWAP
  • TTM SQUEEZE
  • ROC
  • RSI
  • MACD
  • STOCHASTIC

Using Absolute vs. Relative Momentum

Best Practice: Use both types together:

  1. Use relative momentum to identify best/worst performers in a group
  2. Use absolute momentum to assess if current momentum levels are attractive

For single-metric analysis, prioritize absolute momentum as it provides better context for an asset's trading direction.

Why Use Momentum Trading?

Key advantages:

  • ✅ Easy to calculate, track, and interpret
  • ✅ Applicable to any financial time series
  • ✅ Capitalizes on passive flows and HFT market dynamics
  • ✅ Effective across different economic regimes

"If you're going to shoot for fish in a barrel, momentum ensures there are fish in the barrel"

Remember:

  • ⬆️ Positive momentum typically leads to price increases
  • ⬇️ Negative momentum typically leads to price decreases