Everything You Need to Know About Momentum Trading – Introduction
Sir Isaac Newton was one of the most important scientists of his time. His work is still used today in science and other fields. One of his greatest work was on the theory of motion. In it, he stated that an object in motion will always remain in motion until it finds an equal force in the opposite direction. In other words, unless an object in motion finds a counterforce, it will not stop. This theory of motion is used today even in the financial market. Traders use it to show that if an asset is moving up, its price will remain in that direction until the sellers take over. A good example of this is shown in the five-year chart shown below.
In this chart, the S&P 500 has continued moving up in the past five years. Even when there have been pullbacks, the index has continued to recover and move up. Therefore, this is an indication that those people who bought and held the index five years ago have done better than those who decided to move against the upward momentum.
As a trader, you need to know when to identify a trend and when to identify a reversal. A trend starts when the price of a security starts to move up or lower after bottoming or topping. An upward trend happens as traders’ optimism about the market continues. They believe that the security will do better than what the traders expect. A downward trend happens in times when the market participants are less hopeful about the economy.
Riding the momentum is not always easy. To do so, you need to do a few things. First, have a stop loss to protect your account from a downside. The stop loss will help you minimize the risks that you might find when the price reverses. An ideal way to do about this is to use a trailing stop loss. It differs from the conventional stop loss in that it moves up with the price. Therefore, if the price moves up, the trailing stop loss will also move up while maintaining your loss appetite.
Second, you need to monitor your trades carefully. This is because when the momentum is moving up, it is possible for the sentiment to change rapidly. For example, if the reason the dollar index was rising was because of the hopes of a Fed increase, the dollar will fall sharply if the Fed changes the tone. Therefore, you should continue to monitor your trades at all time.
Third, you should pay a close attention to the change in the chart patterns. If you are an experienced trader, you likely understand the way the different candlestick patterns work. For example, if you realize that a hanging man, evening start, or harami is forming, you can do well to exit the trade. Paying close attention to these patterns will help you ride the momentum successfully.
Fourth, you should always size your trades well. Even when you are sure that the asset’s price will move as predicted, you should do the best you can to place small trades. Doing this will help you prevent going all in on an asset, whose price might not go as you had predicted.