|Momentum:||The rate of an assetâ€™s change in value. This is often a by-product of liquidity – the higher the liquidity, the stronger the momentum; the lower, the weaker.|
Momentum describes a situation when market sentiment is moving in one direction with high volume, this is derived from price action. Therefore, when price action is weighted heavily towards one direction, it is known as momentum.
As more market participants are buying or selling depending on the move, momentum will increase as a result.
Essentially if you can identify market momentum early on in its move whether it be to the upside or downside, it will give you a general direction with which to follow in the market.
The benefit of spotting momentum early is that you will be able to maximise on the profitability of your trade.
Whilst momentum is a valuable tool when deciding when to enter a market, it is also a valuable tool when establishing a point at which to exit your trade. A reason to exit a trade may be due to a slowdown in momentum or a reversal.
Slowing momentum generally indicates a change in the market sentiment and tells us that this could be in overbought or oversold territory.
By the same token however, it could also just be that a market is approaching a major price level at which you should be anticipating either break in that level or a reversal.
If you are anticipating a reversal in the market, you may decide to either scale out of a trade or even exit it completely. Bearing in mind some of the most important trading maxims, about not standing in the way of a trend and the importance of avoiding picking tops and bottoms, these price levels are often the most precarious to trade.
When support and resistance levels are either bounced off or breached, the moves can be very sizeable and very rapid. Getting caught on the wrong side could prove to be terminal for your trading account.
Understandably, speculators may want to err on the side of caution and exit or scale out of a trade in order to see what the market decides to do before re-entering the market or scaling in.
If momentum continues and as a result breaks price level, you can scale in or enter a position in line with the trend. Equally, if the momentum shifts the other way, that may provide you with an opportunity to exit the trade and book profit, or to cut and reverse by re-entering the market, riding the momentum in the opposite direction.
It is key to be able to spot this type of move, as they can potentially be the most profitable trades.
Momentum can also be useful for confirming an original trade, for example, you are already in a short position, this trade was originally expected to be a short term trade, you then notice that volume is building up and the market seems to be slowly trading lower, you are already nicely onside so now this trade can be looked at differently, this could now be a longer term trade seeing as the market is moving in the direction you first anticipated.