01 September 2022 • 9 min read
According to Newton’s first law of motion, an object in motion will stay in motion unless an external force acts upon it. In a way, financial markets are the same way. A market can start on a particular price trajectory (an increase or decrease) and sustain this movement within a specific time period. This is called market momentum. It reflects market volatility, sets up a market trend, and mirrors market sentiment.
Bullish or bearish trends signify strong momentum, while reversals suggest weak momentum. Traders take advantage of market momentum to make profits, a strategy known as momentum trading.
In the following article, we’ll learn more about momentum trading and how it works when trading crypto.
Momentum trading is a trading strategy where traders exploit volatility and short-term price fluctuations. They buy assets when they sense an emerging uptrend and sell at the highest price of the trend before a reversal ensues. The mantra of momentum traders is “buy high, sell higher.” Typically, momentum trading is a strategy used by day traders and scalp traders. But given its performance, even long-term traders also apply momentum trading.
Momentum trading/investing was popular in the 1990s, when investors purchased sectors of the market that had the greatest annual earnings or price gains. Following the tech bubble, however, the strategy became less popular for obvious reasons. Recent studies, though, have shown that momentum investing/trading is indeed a viable strategy that has performed well over time.
Richard Driehaus’s funds even prove the point. Although investors such as Warren Buffet, Benjamin Graham, and Peter Lynch had used the strategy, Driehaus is still considered the father of momentum investing in certain circles. Driehaus’s approach was to focus on small and micro-cap stocks valued below $500 million, and mid-cap stocks valued up to $3 billion. For him, momentum investing meant investing in stocks with strong upward movement and then riding this upward momentum for as long as possible. By using this strategy, his mid-cap fund grew by 22.2% in 1999, while the small-cap fund gained 196.6% in the same year.
One study conducted by the University of Sussex in the UK, entitled “Momentum trading in cryptocurrencies: short-term returns” and diversification benefits,” found that momentum trading works well in cryptocurrency because cryptocurrencies do not have intrinsic value and are prone to speculative bubbles. The fact that cryptocurrency is highly volatile makes them a perfect fit for momentum trading. Crypto momentum traders expect currencies that have performed well in the past to also perform in the future.
There are two types of momentum traders: absolute traders and relative traders. Absolute traders consider and analyze only one crypto asset (e.g., Ethereum). Relative traders, on the other hand, analyze and compare the price movements of different assets (e.g., Ethereum and Binance Coin), and then decide accordingly.
Every momentum trader should understand that the success of momentum trading is tied to three factors: volatility, volume, and time period.
Even though momentum trading is a profitable strategy, it is also a high-risk one, which is why risk management is an important skill every momentum trader (and crypto trader, in general) should have. To properly manage risks, there are certain principles that the momentum trader should follow. These include:
There are certain principles for risk management that many momentum traders use. They include:
Liquid assets are the best for momentum trading. Momentum traders should avoid leveraged assets because their price movements do not accurately reflect the value of the underlying asset. Traders should also watch out for news events (such as new features or partnerships) that can cause a sudden surge in an asset’s price.
When applying momentum trading, there are certain loopholes for which traders must be aware. These loopholes carry risks and can cause the strategy to fail. They include:
A momentum trader should be an alert trader. The best momentum trades are triggered by news events that cause a sudden upward trend. Therefore, it is important that a trader gets this news and secures an early position. One of the most opportune ways to acquire the latest information is through the best crypto news websites, which contains a wealth of the very latest news. A perfect entry point offers great rewards with minimal risks. Conversely, diminishing trends are risky and should be avoided.
Good momentum traders know how long they want to hold a position. The longer the holding period, the greater the risk. Often, momentum strategies work well with day trading. Day traders often hold large positions to compensate for their short trading period. On the other hand, traders who have longer holding periods (e.g., multi-day traders) often reduce their position sizes to counterbalance the risk associated with long holding periods.
Momentum is usually determined through technical indicators. These indicators measure an asset’s price speed by comparing the current price with the previous price periods (a given period could be in minutes, hours, or days). The greater the difference between prices, the faster the price movement and the greater the momentum.
These indicators reveal when an asset is overbought or oversold, thus calculating the strength of its trend. Commonly-used indicators include relative strength index (RSI), stochastic oscillator, moving average (MA), and moving average convergence/divergence (MACD).
This indicator is used to analyze recent price changes so as to determine if the asset is currently overbought or oversold. The RSI ranges from 0 to 100, with the overbought and oversold points set at 70 and 30 respectively. An RSI above 70 suggests that the asset is overbought and indicates a sell signal. On the other hand, an RSI below 30 suggests an oversold asset and indicates a buy signal.
An RSI above 70 indicates:
An RSI below 30 indicates:
Like the RSI, the stochastic oscillator also indicates the extent to which an asset is overbought or oversold. Unlike the relative strength index, the stochastic oscillator compares an asset’s closing price with its high-low range over a given period. Similar to the RSI, though, this indicator ranges from 0 to 100, with 80 being the overbought area and 20 being the oversold area.
A stochastic value above 80 indicates:
A stochastic value below 20 indicates:
It’s important to note that the relative strength index (RSI) and Stochastic Oscillator are known as leading indicators because they precede price movements. They are predictive measurements that indicate future price movements using past price data.
The moving average calculates the average closing price of the asset over a certain number of past days (e.g., 20, 50, or 200 days). It identifies the direction of a trend. Short-term traders such as momentum traders rely on short moving averages (e.g., the 20-day moving average).
When the moving average rises, it means that there is an uptrend; when it declines, it indicates a downtrend. Furthermore, the moving average enables traders to spot a crossover. Generally, a crossover refers to a situation where two indicators intersect. For example, a 50-day moving average and a 200-day moving average may intersect.
Crossovers often help the trader detect momentum. A bullish crossover indicates upward momentum. This happens when the short-term moving average crosses above the long-term moving average. By contrast, a bearish crossover signifies a downward momentum. It occurs when the short-term moving average crosses below the long-term moving average.
MACD is an indicator derived from the moving average. It shows the relationship between two moving averages of an asset. Usually, it is calculated as the difference between the 12-period exponential moving average (EMA) and the 26-period EMA. To effectively use MACD, the trader needs to recognize and understand two chart lines: the MACD line and the signal line.
The MACD line is derived from the difference between the 12-period EMA and the 26-period EMA. The signal line, on the other hand, is a plot of a 9-period EMA. If the MACD line crosses above the signal line, it indicates a bullish trend. If the MACD line crosses below the signal line, it indicates a bearish trend.
Traders should note that the moving average (MA) and moving average convergence/divergence (MACD) are known as lagging indicators because they follow price movements. They provide data based on past trends.
High-frequency trading uses complex algorithms to execute ultra-fast transactions. It is usually carried out by institutional investors who trade high-volume transactions. Momentum trading, on the other hand, is a trading strategy that can be used by low or high-net-worth traders. Although time is of the essence in momentum trading, it does not require the use of complex algorithms to hasten the transactions. Momentum trading is more about positioning than speed.
In other words, high-frequency trading and momentum trading are not the same. However, high-frequency traders can use momentum trading as part of their trading strategies. Common strategies used by high-frequency traders include market making and artificial price hikes. As market makers, high-frequency traders place buy orders slightly below the market price and sell orders slightly above the market price. Doing will likely require that they spot momentum that is building. Or they could go one step further to create momentum by causing an artificial price hike since they make high-volume transactions. As you might be thinking, however, this is a controversial strategy.
Momentum trading is all about spotting and seizing the moment. Crypto carpe diem. It is a strategy through which traders can make big, quick gains. However, it requires a substantial understanding of technical analysis and indicators. Also, if used incorrectly, a trader can lose their investment just as quickly as they gained it. Just like every other aspect of the crypto space, using momentum trading requires a thorough understanding of the market, your trading profile and extent of your knowledge, and your overall risk appetite.
Always remember the golden rules of trading: never risk more than you can afford to lose and always do your own research!