Educational Piece: Momentum Trading - a Beginner’s Guide

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Momentum trading is an investment strategy that involves buying securities that have shown an upward price trend and selling those that exhibit a downward trend. It operates on the principle that the strength of the market trends will flow through to the performance of individual stocks. 

What is Momentum Trading?

Momentum traders seek to capitalise on market volatility, buying securities when prices are on the rise and selling them before they start to fall. 

Think of Newton’s first law of motion: an object in motion tends to stay in motion. 

Applied to the stock market, the principle suggests that once a stock starts moving in a certain direction, it often continues to move in that direction for some time.

Of course, while a trend might look solid, market trends can reverse suddenly due to unexpected news or market events.

Key Metrics in Momentum Trading:

Momentum traders tend to use an assortment of the following technical indicators and metrics:

1. Moving Averages: These are used to identify trends by smoothing out price fluctuations. A moving average can help to identify the direction of the trend.

2. Relative Strength Index (RSI): RSI is a momentum oscillator that measures the speed and change of price movements (on a scale of 0-100). 

   • Typically, an RSI above 70 indicates a security is overbought (and prices may soon fall). A technical signal is generated once the RSI crosses back below 70.

   • An RSI below 30 suggests a security is oversold (and prices may soon rise). Likewise, the reverse applies here, with a signal generated once the RSI reaches back above 30. 

3. Trend Lines: These are lines drawn over charts to show the prevailing direction of price, along with any key areas of support and resistance.

A momentum trading example:

Let’s say you’ve noticed that XYZ Mining (not a real company) has been on a bullish run for the last couple of months due to a significant rise in iron ore prices. The 50-day moving average of XYZ has been steadily rising, indicating a potential upward trend.

Here’s how you might apply a momentum trading strategy to this stock:

1. Look at the 50-day moving average. 

2. Let’s say the 50-day moving average has been steadily rising, indicating a potential upward trend.

3. Look at the Relative Strength Index (RSI).

4. Let’s say the RSI for the stock has been around 65 for the past week, suggesting a strong upward momentum without being overbought (a reading of 70+ could indicate an overbought weighting). 

5. You purchase the stock.

6. Once the RSI rises above 75, you decide to sell and take your profit.

The Golden Cross:

An example Golden Cross: the 50-DMA has crossed above the 200-DMA for Healius Limited (ASX: HLS)

To verify a strong momentum candidate at an earlier stage in its growth, you might want to apply a Golden Cross indicator. 

The Golden Cross occurs when a short-term moving average crosses above a long-term moving average. In most cases, traders look for the 50-day moving average to cross above the 200-day moving average.

When this crossover occurs, it can signal a potential uptrend (especially after a prolonged period of a bearish market). Momentum traders might consider this a good time to enter a long position, hoping to capitalise on the anticipated upward trend.

We have a Golden Cross scan on the Market Index website, which updates at the end of each trading day.

Click here to check it out.