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What Are Momentum Trading Strategies?

August 09, 2020 16:24 UTC
Reading time: 8 minutes

Having the right trading strategy is essential in navigating the fast-paced nature of financial markets. While there are a variety of different types of trading strategies available, momentum trading strategies have become increasingly popular in current markets.

In this article, you will learn:

  • What momentum trading strategies are.
  • How to use advanced momentum trading strategies.
  • An example of FX momentum trading strategies.
  • What is the best momentum indicator to use.
  • How to start using free momentum trading strategies in a virtual trading environment by opening a free demo trading account with Admiral Markets UK Ltd.

What is a momentum trading strategy?

Momentum trading is one of the simplest forms of trading styles where traders buy and sell assets based on the strength of its recent price action. The theory is that if there is enough strength forcing price in a certain direction then that move is likely to continue for some time.

This style of trading has become increasingly popular due to how markets have changed over the years. Cleverly programmed algorithms identify assets that are showing signs of strength to the upside or downside and quickly join in on the move with trades taken in nano-seconds. As more traders start to see a given price direction strengthen, they too then jump on creating momentum in the market.

Most momentum traders operate in the middle of a longer-term trend where larger traders have already started to build positions which attracts other market participants. This means that momentum traders rely on 'herd mentality' and 'fear of missing out' which almost forces traders to also take part in the trend. This is why momentum and contrarian trading strategies, as well as momentum and reversal trading strategies, differ from each other. But do momentum strategies work? Let's take a look at a few!

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What are the best momentum trading strategies?

Momentum strategies tend to use momentum indicators to help identify the strength of a price move to see if others will be attracted to it and therefore create some momentum in that market. The indicators used differ depending on which asset class is being traded.

For example, trading momentum on stocks and shares may involve the use of volume indicators. However, using FX momentum trading strategies tend to be the most popular due to the 24-hour nature of the Forex market and the high number of algorithmic trading robots adding to the creation of a momentum based trend.

The two most commonly used indicators to trade momentum are the Relative Strength Index (RSI) and Moving Average indicator. When using FX momentum trading strategies many traders will use a combination of these two types of well-known indicators as they are quite versatile. Traders can use them for longer-term charts as well as on momentum day trading strategies.

Let's learn a little more about the RSI and Moving Average indicator.

Moving Average

The moving average indicator helps traders smooth the price data in order to form a momentum following indicators. There are different types of moving averages such as the simple moving average and exponential moving average which is shown on the chart below:

Momentum trading strategies EMAs on MT5

A chart of EURUSD showing the 20-period exponential moving average taken from the MetaTrader 5 trading platform.

Disclaimer: Charts for financial instruments in this article are for illustrative purposes and does not constitute trading advice or a solicitation to buy or sell any financial instrument provided by Admiral Markets (CFDs, ETFs, Shares). Past performance is not necessarily an indication of future performance.

The above chart shows an example of the 20-period exponential moving average. Other periods that are popular include the 10, 50, 100 and 200. Smaller periods will be used by short term traders like day traders, whereas the higher periods will be used by longer-term traders. This why the most profitable momentum trading strategies for individual investors depends on the individual's style and preference.

While many free momentum trading strategies would just use one indicator, most advanced momentum trading strategies use a combination of two and sometimes more. For example, the moving average can help traders identify the direction of momentum, whereas a momentum oscillator can help pinpoint turning points for possible entries as we discuss next.

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Relative Strength Index (RSI)

The RSI indicator was developed by J. Welles Wilder and is known as a momentum oscillator. The indicator aims to measure the speed and change of price movements and oscillates between zero and 100.

The basic formula for the indicator is:

  • RSI = 100 – [100 / ( 1 + (Average of Upward Price Change / Average of Downward Price Change ) ) ]

Fortunately, the MetaTrader 5 trading platform provided by Admiral Markets already provides this indicator which is ready to go. There are a variety of ways to actually use the indicator. It is widely considered that a market is overbought when the RSI is trading above the 70 and oversold when trading below the 30. Traders will also use the indicator for divergences when trading reversals.

The chart below shows an example of the RSI (3) indicator:

Momentum trading strategies RSI on MT5

A chart of EURUSD showing the RSI (3) indicator taken from the MetaTrader 5 trading platform.

Disclaimer: Charts for financial instruments in this article are for illustrative purposes and does not constitute trading advice or a solicitation to buy or sell any financial instrument provided by Admiral Markets (CFDs, ETFs, Shares). Past performance is not necessarily an indication of future performance.

Momentum trading strategy example

By combining the two most popular types of momentum indicators traders can start to build the beginning of a potential strategy. These are just hypothetical ideas based on theory and it's best to start with a demo trading account to see the effectiveness of any tools or strategies you decide to employ. After all, a trade could either win OR lose so it's best to get used to the psychological impact of both.

An example strategy idea could be:

  • Long: If the price is above the 20-period exponential moving average and RSI (3) is oversold.
  • Short: If the price is below the 20-period exponential moving average and RSI (3) is overbought.

The yellow boxes below shows just some of these rules being met on the H4 EURUSD price chart:

Momentum trading strategies RSI and EMAs on MT5

Source: Admiral Markets MetaTrader 5, EURUSD, H4 - Data range: from 24 June 2020 to 7 August 2020. Please note: Past performance is not a reliable indicator of future results. Last five-year performance: 2019 = -2.21%, 2018 = -4.47%, 2017 = +14.09%, 2016 = -3.21%, 2015 = -10.18%, 2014 = -12.23%

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Did you know that you are able to test your trading ideas and theories on thousands of different instruments by opening a FREE demo trading account? By opening this account you can trade in a virtual trading environment until you are ready for a live account.

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About Admiral Markets

Admiral Markets is a multi-award winning, globally regulated Forex and CFD broker, offering trading on over 8,000 financial instruments via the world's most popular trading platforms: MetaTrader 4 and MetaTrader 5. Start trading today!

This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or recommendation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.

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