How to use momentum in CFD trading

  • By Jeff Cartridge

  • November 13, 2018
  • 2:13 am BST

Many CFD traders use momentum as their primary guide when deciding when to enter and exit positions. They monitor price action closely, looking for strong upward or downward trends, then take either a long or short position with the expectation that the price movement will continue in the same direction. True momentum traders focus on the short term. They are often day traders, entering and exiting positions quickly and closing out all their positions at the end of the day.

How is momentum trading different from other types of trading?

Momentum trading can look like other trading strategies. Most traders monitor trends in the markets and pay close attention to price action, but a true momentum trader pays attention to very little else. These traders rely on the simple but proven fact that when prices have steadily and reliably increased or decreased in the very recent past, then they invariably will continue in the same direction in the near future.

This can sound like a dangerous assumption, as financial instruments can and do fluctuate. Markets range and trends cannot be relied upon, but momentum trading does work for traders who truly understand the concept and know how to read their technical indicators correctly to identify true momentum.

Once correctly identified, the momentum that traders look for is surprisingly reliable. In fact, a market-wide reversal in momentum is so rare that it causes the type of crash that makes national news. We are not talking about a dip or market correction here. They happen regularly, and while they are worrisome in the short term, markets bounce back quickly. A global, market-wide reversal in momentum is much more noticeable. It was behind the market crash of 2009, for example, but such crashes are extremely rare. They can happen, of course, but in most of the markets, most of the time, momentum can be relied upon.

How do you identify momentum using technical indicators?

This is a vital question because not every rise or fall in the markets represents momentum. While momentum itself is a reliable concept to build your trading strategies on, identifying momentum is difficult. Experienced CFD traders look at a range of data from several sources, often using a few different technical indicators, such as the Relative Strength Index (RSI), the Rate of Change (RoC) indicator and the Average Directional Index (ADX).

By drawing data from a range of technical indicators, experienced traders can create a picture of what is happening in the markets and identify whether momentum actually exists. Most traders agree that an ADX of over 25 is necessary to indicate momentum. However, that alone is certainly not enough to make trading decisions. The RoC is also important., as it generates a trend line that measures price changes over a set number of trading periods. Trends must be rising or dipping above or below the zero line to suggest an increase or decrease in momentum. The RSI is significant because it allows for a comparison of recent gains and losses to assess whether an instrument is overbought or oversold.

Every trader has his or her own favourite set of indicators. The above are simply three that can combine to help identify momentum. As is always the case with technical analysis, one important thing to remember is to never be over-reliant on one particular indicator. They are all useful tools, but any one used in isolation cannot be fully trusted. Identifying momentum is complicated and requires an approach based on technical analysis of a few different indicators.

Can fundamental analysis indicate momentum?

Some traders certainly include fundamental analysis in their strategy to help them identify momentum. They will look at specific events that may affect a company, industry, country or the global economic climate to identify when a stock, currency or other instrument may experience an increase or decrease in momentum. Event-based momentum traders have more in common with fundamental traders, but while many fundamental traders look at longer-term trends, momentum traders still generally focus on the short term. Some traders, especially those who are highly focused on technical analysis, sometimes forget that a specific event can significantly impact price movement in the short term, creating a sharp increase or decrease in momentum over a few hours and giving day traders the opportunity to make a series of profitable trades.

Which trading strategies do momentum traders use?

Momentum traders are looking for a strong, continuing trend in one direction, usually with a high trade volume over a brief period. As with many trading strategies, this will often involve monitoring a daily watchlist and following trade volume closely. High volume is an important signal that significant price movement is occurring and may well trigger momentum. Traders looking for indicators of momentum are also monitoring instruments that are pushing past their resistance levels. This can indicate that a previously ranging market is gaining momentum.

What are the risks with momentum trading?

All trading carries risk, and momentum trading carries more than many other types. Swing traders who know about basing buy and sell decisions on points of resistance will find it hard to hold their position and trust in momentum as they watch stocks or currencies pushing well past those levels. Experienced traders use momentum in their strategies purely because there is a possibility of much higher returns than with more conservative strategies. As all traders know, potentially higher returns generally come with a higher potential risk.

What are the rewards?

As we have mentioned, the challenges with momentum trading revolve around learning to correctly identify it and then putting sound strategies into place to profit from it. For those who manage this, there is a high-profit potential. Mastering momentum provides traders with an opportunity to leverage market volatility and take advantage of the investor emotion that seems to keep traders buying or selling a stock or currency once a strong upward or downward trend is in place.