Use the Momentum Rule in Day Trading: Full Guide

All you have to know about Momentum Trading and how to use it as a day trader

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, instead, happens in times when the market participants are less hopeful about the economy.

To be successful at day trading, you should learn as much as possible about the most effective rules and indicators. The momentum rule is a prime example.

By understanding what it means and how to use it, you will have an easier time making profitable trades.

What is the Momentum Trading Rule?

As someone who has been active in stock trading and investing, you should already be familiar with the significance of the zero line.

Put simply, it represents the point at which the current price is the same as the price a certain number of days ago.

The role of the ‘Zero Line’

The zero line plays a crucial role in the momentum trading, which dictates that you should buy when the momentum indicator crosses above the zero line and sell when it dips below it.

Why would you do that?

When the momentum indicator rises above the zero line, it means the price is trending upward, so it’s a good time to buy.

When the momentum indicator drops below the zero line, the price is trending downward, so you should sell.

Divergence and Momentum

Although the concept of momentum is simple enough to grasp, many traders are thrown off when divergence comes into play.

On most charts, a line pointing upward represents an increase in value. However, with momentum, an upward line reflects the speed of a price change.

When analyzing a chart, remember: the price can increase while momentum drops. This is known as divergence.

When do divergences occur?

Basically, it occurs when momentum moves in the opposite direction of a price trend.

Also, it is possible for momentum to move higher or lower but not to reach the same high or low as the previous peak or valley. Meanwhile, the price trend may be reaching a new high or low.

Recognizing Momentum on a Chart

momentum chart

Take a look at the figure on this page for a minute. As you can see, the price is reaching a new high. About midway through, though, it stops creating new highs and moves in the opposite direction.

Shortly after that, it flattens out.

Momentum typically peaks before the price does, which produces a divergence between the movement of the price and the movement of the momentum. This is a clear sign to buy or sell right away.

Momentum Trading Strategies

Riding the momentum is not always easy. To do so, you need to do a few things.

Have a Stop Loss to protect your account from a downside

First of all, 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.

Monitor Your Trades

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.

Look for Change in Chart Pattern

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.

Size your Trades

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.

Using Momentum as a Confirmation Rule

Momentum is popularly used alone to detect buy and sell signals. It can also be used as a confirmation indicator. Under the confirmation rule, both indicators need to agree before a trade is made.

It’s wise to do this for a few reasons:

  • reduces the number of whiplash trades
  • reduces the total number of trades
  • increases the odds of making profitable trades.

In conclusion, by having a firm grasp of momentum indicators and how they work, you can increase your success in the world of day trading.

Study more examples to ensure that you recognize momentum indicators when they occur.

By heeding them, you will have an easier time making profitable trades.

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