Beginner’s Guide: What Is Momentum Trading & Its Strategies?

Cryptocurrencies are highly volatile, and trading crypto would require an excellent strategy to secure consistent profits. Most beginners have many options, most of which are adopted from forex and stock trading. But momentum trading is one of the best trading styles thus far for crypto trading. 

The strategy reflects the expression “trend is your friend” perfectly well. While there is no strategy without risks, momentum trading gives traders more control and fewer potential failure points.

Momentum trading is a strategy or trading style in which traders assess the strength of a current trend to open positions in its direction. The primary rationale behind momentum traders’ moves is that if there is enough force driving a price move, then it will continue to move in the same direction for a while.

How Does Momentum Trading Work? 

In physics, we say that if an object moves in a particular direction, it continues to do so until an external force interferes in its motion and changes its direction. So is the case with financial assets – they tend to move in a specific direction until new information reaches the market and affects investor sentiment.

For example, when a cryptocurrency increases in price, it attracts more attention from both retail and institutional traders. As a result, it pushes the price even higher. Sometimes the uptrend creates a fear of missing out (FOMO) effect, and the price continues to increase for much longer than it would actually do based on fundamentals alone. The uptrend may continue until a large number of sellers or whales believe that the price is exaggerating and doesn’t reflect the intrinsic value.

Hence, they open short positions en masse. When the trend reversal happens, and momentum traders exit the market.

However, if the new downtrend is gaining traction, momentum traders may enter the market again. But at this time, they go short. In this way, momentum traders can benefit from both trends with great success.

Key Metrics to Understand Momentum Trading

The first task of a momentum trader in crypto or stock is to assess a trend’s strength before opening a position. The strategy involves the analysis of three key metrics to understand the momentum of a trend. These are volume, volatility, and timeframe.

Volume

The volume suggests how many traders have opened positions in the direction of the trend in a given period based on the number of assets traded. For example, if the number of assets traded is high, we may assume that the trend is healthy and gaining momentum since there might be many traders involved. Still, sometimes the trading volume can be manipulated by whales. That means financially capable traders can buy or sell large amounts of the asset.

Volatility

Volatility is another important aspect of the price that is closely monitored by momentum traders. They prefer volatile markets to gain from the short-term ups and downs, and cryptocurrencies, including BTC and ETH, are the most suitable asset group.

Timeframe Analysis

Finally, momentum trading is closely related to the timeframe selected by a trader since the trend is making sense only within a specific timeframe. For example, Bitcoin can increase on the hourly chart, but that may be a temporary swing as it declines. If the trend on several timeframes coincides, then this considers as a stronger momentum.

What Are the Characteristics of Momentum Trading?

Before conducting technical and fundamental analysis for momentum trading, traders should know that there are two main approaches to implement this strategy — relative momentum and absolute momentum.

Relative Momentum

In relative momentum, traders would compare different cryptocurrencies to see whether they do better than the rest or perform much worse than the rest. Momentum traders would then buy strong performing coins and sell those they consider the weakest. For example, in June-July 2020, several tokens surged amid the DeFi and yield farming hype, and they performed much better than Bitcoin and other peers. Relative momentum traders would buy the DeFi tokens in such a case.

In October-November 2020, Bitcoin has regained dominance and surged to the highest level in about three years, while other coins haven’t shown similar returns. In this case, momentum traders would favor Bitcoin due to its stronger momentum.

Absolute Momentum

Another approach is absolute momentum. It occurs when traders analyze the price of a cryptocurrency or any other asset separately. They compare the current price of the coin with its past performance alone. 

Most of the momentum strategies today involve absolute momentum. For example, the Bitcoin price has accelerated in mid-October and jumped from less than $12,000 to more than $18,000 within four weeks. This acceleration suggests that positive momentum is there, and traders would be interested in going long until the trend is reversing.

What Are the Best Momentum Indicators?

For momentum traders, technical analysis is critical because it helps traders define the forex, stock, or crypto market trend and analyze its momentum. Here are some essential technical indicators to find momentum with greater precision:

Average Directional Index

The average directional index (ADX) is probably the simplest and most popular indicator to determine the strength of a trend. The purpose of ADX is to evaluate momentum for better judgment in an asset. 

Basically, ADX is an oscillator, and its calculations are sophisticated but effective for price trend analysis. You should know that it reflects the strength of a price trend on a graph whose line fluctuates between 0 and 100. When the reading dips below 30 suggests that the price is moving sideways. As the ADX breaks above 30, it means that the price is trending. Ultimately, the higher the ADX goes, the stronger is the trend in a particular direction. 

However, do note that the ADX doesn’t show whether a trend is bullish or bearish as the indicator is focusing on momentum alone.

Here is how it looks on the chart:

Average directional index indicator chart

Moving Averages

Moving averages (MAs) are the oldest and most common technical indicators out there. They are popular for decades to analyze all kinds of assets, and it’s all for good reasons. Part of the trend indicators group, MAs, cut the price action’s noise to smooth volatility that confuses traders and displays the general trend.

Traders use MA to calculate the average of a cryptocurrency price movement over a given period. For momentum traders, moving averages are important because they can show whether a trend continues its direction or tends to go sideways. It is visually apparent as the MAs follow the price action.

Traders would generally use two MAs with different periods. When the shorter MA crosses the longer MA, then the existing trend may be reversing, and momentum traders would be interested in closing positions.

RSI index trend analysis in momentum trading

Relative Strength Index

The relative strength index (RSI) is one of the most popular oscillators, which acts as a momentum indicator. It calculates the size and magnitude of the latest price changes.

The RSI line is plotted on a separated chart below the price action and fluctuates between 0 and 100. If the RSI goes below zero, it shows an oversold level, suggesting that the current downtrend might reverse. 

On the flip side, if the RSI goes above 70, the market enters an overbought level, meaning that the current uptrend is losing momentum and might gradually turn into a downtrend or move horizontally. Thus, momentum traders should be on alert whenever the RSI is above 70 or below 30, as the bullish or bearish sentiment is reaching oversaturation, and the trend is changing.

MACD momentum trading trend analysis

MACD

Moving Average Convergence Divergence (MACD) is a bit more sophisticated. It behaves both like momentum and trend-following indicator. The MACD merges two exponential moving averages (EMAs), and its result is calculated by subtracting the 26-period EMA from the 12-period EMA. However, the two lines displayed on the MACD chart are not the two EMAs used by the indicator. Instead, one of the lines is the MACD line, and another one is the signal line, which can determine changes in price momentum and provide buy or sell signals. There is also a histogram, which represents the difference between the MACD line and the signal line.

When the two lines depart from each other, momentum is considered more substantial, and traders can rest assured that the current trend would continue.

MACD momentum trading trend analysis

Stochastic

Stochastic is yet another reliable oscillator not only in momentum trading but in swing or day trading too. While it possesses a similar trait and functionality to RSI, it uses an entirely different calculation methodology. In fact, the indicator compares the most recent closing price to the range of its previous prices in a given period.

It is plotted on a separate chart the same as the RSI and fluctuates between zero and 100. Stochastic also displays overbought and oversold levels, but at this time they are considered above 80 and below 20, respectively. The indicator has two lines – the Stochastic line, which ranges between the overbought and oversold levels, and the signal line, which can cross the indicator line to anticipate trend reversals.

So, crypto momentum traders would be interested in exiting the market when the two lines cross or when the indicator maintains within the overbought or oversold zones.

Commodity Channel Index trend analysis in momentum trading.

Commodity Channel Index

The commodity channel index (CCI) is a momentum indicator used to determine a trend’s strength. The indicator calculates the difference between the current price and the historical average price for a given period. When the CCI is above zero, positioned at the middle of the CCI chart, it indicates that the price is above the historical average. 

When the CCI is below zero, then the price is below the average. If the CCI goes higher than 100, it suggests that the price is well above its historical average, and the uptrend is strong.

Stochastic momentum index chart

Stochastics Momentum Index

The Stochastic Momentum Index (SMI) is an improved version of the Stochastic, which pays more attention to closing prices. It measures the distance of the current closing price related to the recent high/low range median. It is also used to determine overbought and oversold levels.

What Is the Best Momentum Strategy?

There are many momentum strategies that involve several technical indicators or chart patterns to provide buy or sell signals. Perhaps, one of the simplest but still reliable strategies that you can test on your trading platform.

For this, you will need to set an exponential moving average (EMA) with period 19 and the ADX indicator.

Buy in strategy in momentum trading

Here are the buy conditions:

  • Check whether the ADX is at 30 or above – it shows that the price is trending.
  • Check whether the EMA is pointing upwards – it suggests an uptrend.
  • Wait for a candlestick to close fully above the EMA and enter a long position.

You can exit the market manually when the price crosses EMA. Don’t forget to check the volume from time to time – higher volume suggests stronger momentum, thus signaling a more accurate indicator to buy.

Exit strategy in momentum trading

On the contrary, if you intend to go short with this strategy, you should meet the following conditions:

  • Check whether the ADX is at 30 or above – note that the ADX shows the trend’s strength rather than direction.
  • Check whether the EMA is pointing downwards – it suggests a bearish trend.
  • Enter the market after the first candlestick that closes below the EMA with its full body and shadows.

The Benefits of Momentum Trading

Momentum trading is an excellent style for beginners because of its simplicity. Here are some benefits to this approach:

  • Momentum trading can be profitable since it follows the trend;
  • It can work with any timeframe and thus suit both day traders and swing traders;
  • Momentum trading allows cryptocurrency traders to leverage high volatility.

The Risks of Momentum Trading

Obviously, there is no trading strategy without its risks. Momentum trading is very dependent on the trend, and sometimes traders can be taken by surprise by unexpected trend reversals. It’s important to note that technical analysis indicators cannot always anticipate reversals since they analyze past prices. Also, prices can move up and down without any prior clues due to unexpected events or large trades from whales.  

Momentum Trading Risks Management

To succeed with momentum trading, you have to apply proper risk management techniques and stick to the strategy you choose. Here are a few aspects that you should consider:

  • Entry point – opening the position is probably the most crucial moment of this trading style since it can lead to profits or losses depending on whether the trend continues its move or reverses. Make sure to avoid entering the market during overbought and oversold levels.
  • Best time to momentum trade – if you trade stocks, you would be interested in trading during the US session, especially in the afternoon New York’s time (EST). Forex traders would wait for the US and European trading sessions. However, cryptocurrency traders can trade at any time since the market is active 24/7. Still, check for the US and European sessions since traders may be more active then.
  • Support and resistance – don’t forget to monitor the trend’s support and resistance lines. For instance, if you have long positions and the uptrend is touching its support level, be ready to intervene.
  • Position management – make sure to check your positions regularly. It’s best to pay attention to the volume and volatility. If the volume declines, it might suggest that traders are losing interest in backing the current trend anymore and are waiting for a reversal.
  • Stop loss and take profit – don’t hesitate to use these fundamental stop orders to automate your trades and limit your potential losses.
  • Exit point – the exit point is another pivotal moment that can decide the profitability of a trade. Whenever you see clear signs of a trend reversal, make sure to close your positions. Trend reversals might be anticipated by MA crosses and overbought or oversold levels displayed by Stochastic and the RSI indicators.

How to Start Momentum Trading?

You can start momentum trading by following these simple steps:

  1. Decide: on a cryptocurrency you intend to invest in, be it Bitcoin or an altcoin. You can choose the cryptocurrency based on the relative momentum approach, as explained above.
  2. Build: a momentum trading strategy based on the described indicators or use a ready-made one, like the one shared above. The important thing is to stick with it when trading live.
  3. Test: your strategy on a demo account and check it on historical prices on the chart to see whether it provides accurate signals regularly.
  4. Modify: when you feel confident, start trading with live markets by depositing what you can afford to lose.

Make sure to use risk management techniques to secure consistent profits.

The Bottom Line

All in all, momentum trading is one of those universal strategies that are suitable for both beginners and professionals. The great thing about this style is that it can do a great job with any timeframe higher than H30. Thus, it can be implemented by both day traders and swing traders.

Another major benefit is that momentum trading is backed by a lot of technical indicators that were designed precisely to determine the strength of a trend.

FAQ:

Is Momentum Trading Profitable?

Yes, but that depends on your strategy and profile. Momentum trading is becoming less profitable in the stock market, but it can do a great job in the crypto space due to the high volatility.

Who Is Suitable for Momentum Trading?

Momentum trading is ideal for those traders who prefer to emphasize clear trends and capitalize on them. Whether you’re a beginner or an advanced trader, momentum trading is a great choice. Ultimately, you should trade with a style that suits you best. Learn how to trade cryptocurrency here.

*Disclaimer:

Trading involves a substantial risk of loss and is not suitable for every investor. The valuation of crypto trading may fluctuate. None of the content published on Bybit.com constitutes a recommendation that any particular security, portfolio of securities, transaction, or investment strategy is suitable for any specific person. All trading strategies should be used at your own risk.

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