What is Momentum Trading?
This is a form of trading that has been popular on Wall Street and among day traders for decades, and essentially boils down to the mantra of “buy high, sell higher”. Momentum trading is not without its risks, but when done right, it can prove to be a winning and sustainable long-term forex trading strategy. With that in mind, read this essential guide to momentum trading to find out everything you need to know.
Momentum trading is not only applied to forex trading – it is also a hugely popular approach in markets such as equities, futures, and commodities. As the name suggests, the strategy describes an attempt to capitalise on the momentum of a rising asset. The goal is to identify assets that are undergoing early moments of an upward price swing.
The goal would then be to buy that asset, ride the wave, and then attempt to sell that same asset when you think the wave has peaked, pocketing the price difference as pure profit. Many beginner traders tend to be unsure about momentum trading, as it seems to go against the age-old motto of “buy low, sell high”.
However, momentum trading can be an effective and easy way to boost your profit margins. After all, it is arguably easier to identify a stock or currency that is already on the rise than it is to identify an asset that will increase in value at some point in the future.
Momentum trading is usually a very short-term strategy, which is why it is so popular among day traders and those involved in forex markets. The entire goal of momentum trading is to capitalise on volatile markets to exploit short-term uptrends, before dumping those volatile assets before they begin to decline again.
It is a very news-focused form of trading, as the most volatile assets tend to be intensely vulnerable to short-term news cycles and general macroeconomic developments. The idea is that a trader would buy an asset, sell shortly after once the short-term trend has peaked, and then use that profit to invest in the next uptrend.
It is these short-term, volatile, and news-focused elements that make momentum trading ideal for many major and minor forex markets, as we shall see below.
Momentum trading was first popularised in the 1990s, when US stock markets were white-hot and the Dot Com Bubble was about to reach its zenith. Given that markets were largely characterised by periodic frenzies and massive asset price increases, a group of fund managers on Wall Street decided to take advantage of this.
The idea was to examine markets by sector and identify which ones had the best previous year or quarter. All the better is the year or quarter before that was not as strong, as this would suggest that the current upward price trajectory for a type of asset could be the beginning of a trend. Various funds would then be instructed to buy into that sector and hold it for a quarter or a year, before selling it off at a profit.
The practice seemed to work well enough for investor gurus such as Richard Driehaus, who took the practice worldwide by publishing a number of best-selling books on how to become a successful momentum trader.
Driehaus claimed that his fund, Driehaus Capital Management, saw annual returns of more than 30% for 12 straight years, purely as a result of momentum trading. The strategy waned in popularity after the Great Recession, only to have re-emerged in recent months and years as a result of the bullish markets we now find ourselves in once again.
How does Momentum Trading work?
Let’s break down exactly how momentum trading actually works in practice. First, it is worth emphasising that, since momentum trading hinges on volatility, you should focus your investments on individual assets such as forex pairs or a commodity, rather than ETFs of index funds.
Timing is everything with momentum trading, as you need to be able to enter a position at the right time and exit that position before it is too late. Let’s say you wish to apply a momentum trading strategy to GBP/EUR, which we’ll say is currently trading at 1.1600.
You might do so because you have noticed that GBP/EUR has grown a few pips in the past few hours, ahead of some news that is likely to show that FDI into the UK has surged, while EU FDI has fallen. The perfect momentum trade would exploit this news shock at just the right moment, piling into the Pound just before the news causes a rally that you can take advantage of.
In this hypothetical scenario, GBP/EUR peaks at 1.1800 before falling back again. If you sold at this peak, you have successful completed a momentum trade.
Choose Momentum Trading as your strategy
On paper, momentum trading might seem like an easy enough way to make a quick profit. However, this is not the case. Timing your trades and exiting them at the right time is a form of alchemy that even the most seasoned Wall Street investors are yet to master.
When done right, the pay-offs can be life-changing. However, it is all too easy to miscalculate and lose out. That’s why you need to be fully aware of the advantages and the risks of momentum trading before you begin.
The advantages of Momentum Trading
There are a number of advantages to momentum trading over other popular strategies, such as:
- An opportunity to take advantage of highly volatile markets such as forex
- Take advantage of trends driven by other traders, with less risk for you
- Relatively easy to track market factors that drive upward trends in volatile markets
The risks of Momentum Trading
That being said, there are also a number of significant risks that any trader should be aware of before attempting to participate in momentum trading:
- Although the number of factors involved can be limited, a huge amount of research is required before you can accurately predict reliable upswings
- Momentum trading only really works when markets are bullish – bearish markets are anathema to momentum traders
- Exiting a trade too early can easily mean that lots of potential profit is lost
- Conversely, entering a trade too late means you will likely lose your initial investment
Momentum trading started off as a way to take advantage of the white-hot S&P 500, but now it is routinely applied to a wide range of asset markets. One of the most popular markets for momentum trading is forex.
This is because the vast majority of the world’s currencies are “free floating”. This means their value relative to other currencies is entirely dependent on general market sentiment. This is why when there is negative GDP data coming out from, say, Turkey, the value of the Turkish Lira goes into free-fall. As such, forex markets are very volatile, extremely sensitive to news shocks, and subject to dizzying upward trends.
For example, you may have noticed that, when global economic sentiment is trending down, the value of the US Dollar relative to other currencies will shoot up, as global investors pile into this “safe haven” currency. A good momentum trader would recognise when this trend was beginning and buy into the Dollar, selling once the panic has begun to fade and the price of USD is likely to start falling again soon.
How to start Momentum Trading?
To start momentum trading, it is essential that you have access to a trustworthy forex broker that can give you direct market access and which relies on real market data. That broker should also provide you with a wealth of resources and financial news, so that you can stay informed about the markets you are interested in and develop an ability to identify emerging uptrends.
It is essential that you select brokers that can provide you with markets that have plenty of liquidity, as being able to buy and sell at the exact second you want to is crucial for successful momentum trading. You should also register for signals and alerts from brokers so that you can automatically receive updates on potential forex upswings.
Use a Forex Broker You Can Trust
Successful momentum trading in forex depends on the broker that you choose. To find a licensed broker that can provide you with the resources and market insights you need to trade successfully, we have got you covered. Make sure to consult our expertly curated broker reviews to find the right UK brokerage platform for you.