What Exactly Is Momentum Trading? Taking Advantage of Market Volatility

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Momentum trading is a method that may be used on both the stock market and cryptocurrency. In both cases, the term “momentum” indicates the same thing as “underlying trend strength.”

Momentum traders profit from market volatility by focusing on short-term price fluctuations. They purchase assets when they sense a beginning upswing and sell coins or tokens at the peak before the price falls again. In other words, momentum traders adhere to the principle of “buy high, sell even higher.”

The momentum trading approach proposes that once an asset has gained propulsion, its upward or negative trend will continue. The scientist Isaac Newton originated this concept when he realized that moving things normally continue in motion until interrupted by an external source.

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?

The time frame in which a trader hodls a coin to earn a profit is one of the key differences between momentum trading and long-term investing. Momentum traders regularly acquire and sell assets. They are always on the hunt for new uptrends and profitable purchasing chances. As a result, momentum trading is a very active trading strategy in which traders employ technical analysis tools.

Long-term investors, on the other hand, typically choose coins that have the potential to increase in value over time and hold them for an extended length of time. This is a more passive strategy, since many purchasers may invest without giving much thought to their assets, hoping for a rise in value over time.

Although momentum trading is typically connected with short-term tactics such as day trading or scalping, it may also apply to long-term investors if the trend persists for an extended length of time. While market volatility is unpleasant for many long-term investors, it is what momentum traders rely on to earn money. Finally, one’s distinct trading style is determined by a variety of elements such as personality type, risk tolerance, and personal preferences.

How Does Momentum Trading Work?

Momentum traders primarily rely on technical analysis, statistical probability of historical market movements, and indicators of future price rises and decreases. As a result, momentum trading ignores information about the asset’s use-case, politics, or the global economy, which might impact the price. Instead, the following characteristics are often important 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?

A variety of technical indicators might be useful in momentum trading. The moving average is one of the most often used. Essentially, by monitoring the moving average, a trader may notice a developing trend and significant momentum. The MACD indicator (moving average convergence divergence) is a popular instrument for spotting both market momentum and probable trend reversals.

Support and Resistance levels

Furthermore, momentum traders look for probable trend pauses and reversals by analyzing support and resistance levels. On a price chart, the support level is where traders forecast a halt or reversal in a decline owing to a concentration of demand. In contrast, resistance occurs when a concentration of supply causes an uptrend to stall for a short period of time. When the price breaks through one of these barriers, it becomes more volatile and develops traction.

Bitcoin-Support,-Resistance,-trendlines

Figure 1: Support and resistance levels (Source: Phemex Academy)

Candlestick Patterns

Candlestick patterns created by price activity on the charts may also be of interest to momentum traders. These patterns can be bullish or bearish, indicating an impending price upswing or decline. Several formations are seen here, and you can learn more about them in our comprehensive guide to the most notable candlestick patterns.

The piercing line

Figure 2: The Piercing Line candlestick pattern indicating an uptrend (source: Phemex Academy)

the hanging man

Figure 3: The Hanging Man candlestick pattern indicating a bear market (source: Phemex Academy)

The Bearish Engulfing

Figure 4: The Bearish Engulfing candlestick pattern indicating a downtrend (source: Phemex Academy)

The Relative Strength Index

The Relative Strength Index, abbreviated as RSI, is another useful instrument for forecasting future market moves. When the RSI surpasses 70, an asset is deemed overbought, indicating that its price is likely to fall. An RSI of less than 30 suggests that the asset has been oversold and that a price gain is likely.

Although technical analysis may be used to forecast market movements, its indications should never be used in isolation. For example, a trader should never rely solely on candlestick patterns since they are readily misconstrued, particularly by rookie traders.

What Are the Pros and Cons of Momentum Trading?

Pro: Momentum trading can be profitable

Momentum trading has the potential to be extremely rewarding. Because of the tremendous volatility of the crypto market, this method works especially well with digital assets. Momentum traders frequently make significantly more money in a shorter period of time than long-term traders. Furthermore, using technical analysis to forecast price movements is a good approach to not only generate rapid profits in a bull market but also to forecast the emergence of a decline. In this instance, it may be wiser to safeguard your asset against a significant price drop by purchasing 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

Furthermore, previous performance is no guarantee of future price movements. A trend may always reverse without warning, and research claiming to demonstrate the advantages of momentum trading over long-term investments may be incorrect. They do not apply to all trading circumstances because the effectiveness of the technique is dependent on the market environment. For example, while momentum trading works well in a bull market, it may be deceptive and lead to significant losses in bear and bull traps. In certain instances, all technical indicators are pointing in one direction but the price is moving in the opposite direction.

Should I Engage in Momentum Trading?

Trading momentum is not for everyone. To be effective with this trading strategy, you must have technical expertise as well as plenty of practice studying the market. It’s also important to have the correct personality type. If you are easily worried by the market’s turbulent fluctuations, and you tend to make impulsive decisions and indulge in FOMO, long-term investment may be a better fit for you.

Furthermore, you should be aware that any form of short-term trading necessitates ongoing market study and interaction. To maximize your gains and minimize excessive losses, you must be able to enter and quit at precisely the proper time. 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.

Conclusion

Momentum trading may help traders achieve a large profit in a short period of time. However, a working knowledge of technical analysis and particular signs of a forming uptrend or downturn is required. The pace at which you may earn from the momentum trading method is the same rate at which your assets might lose value. Long-term investment may be more beneficial for you than momentum trading, depending on your personality type and interests.

Finally, traders do not have to stick to a single method. Once you have a solid understanding of technical analysis, you may mix multiple strategies to develop your own distinct trading strategy.

 

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