Momentum trading is grounded in the idea that securities that have recently performed well will continue to do so in the short term, while those that have underperformed will continue to lag.
A key issue in momentum trading is to identify the trend as early as possible to maximize the strategy’s returns and avoid entering close to a trend reversal when the returns would be negative. As such using intraday data indicators as opposed to end-of-day indicators is essential in generating trade entry and exit alerts.
Price Patterns and Breakouts
Technical traders and analysts use chart patterns, indicators, and technical analysis tools to identify and confirm these breakouts.
Resistance or Support Level: A breakout occurs when the stock price breaches a well-defined resistance level or support level. Resistance levels are price points where selling pressure has historically been strong, preventing the stock from moving higher. Support levels, on the other hand, are price points where buying interest has historically been strong, preventing the stock from moving lower.
Symmetrical Triangle Breakout: This occurs when the stock's price moves out of a symmetrical triangle pattern, which typically signals a continuation of the prevailing trend.
Head and Shoulders Breakout: A head and shoulders pattern is a reversal pattern. A breakout below the neckline of this pattern can indicate a bearish reversal.
Cup and Handle Breakout: This pattern resembles the shape of a tea cup. A breakout above the handle portion is considered bullish.
Double Bottom or Double Top Breakout: These patterns indicate potential reversals. A breakout above the double top or below the double bottom can signal a change in trend direction.
Volume Confirmation: One of the critical aspect of a breakout is that it should be accompanied by an increase in trading volume to confirm that there is significant momentum behind the move.
This is typically done on a very granular level using shorter timeframes than the indicator timeframe. For example, if a derivatives trader was generating signals using 5-minute options data bars then the volume analysis should be using 1-minute or even tick-level data to ensure there was sustained volume during the period and not just a single large trade.
Moving Averages
Moving averages help traders in filtering out the noise of trading patterns and identifying key trend lines. A typical setup is to generate a fast a slow-moving MA (the slow MA should be approx. 5x the fast MA) and use the crosses as signals.
For example, the 5-minute moving average and a 30-minute moving average (calculated using 1-min bar data) with a buy signal generated when the 5-min average crosses above the 30-min average. It is important to use the spot the clarifying the trade signals, so the spot should always be above both moving averages for a buy signal.
Relative Strength Index (RSI)
RSI is a momentum oscillator that measures the speed and change of price movements. It is the ratio of the total gains versus losses in a given period (typically 14-time units such a 1-minute or 30-minute bars).
A ratio above 70 typically indicates an overbought situation and below 30 an oversold situation.
RSI is often combined with moving averages to confirm a signal and avoid trading just prior to a trend reversal.
Overall, momentum trading is most effective during periods when there is little news driving market moves and the trading is driven more by intraday supply and demand imbalances.
