How to Use Momentum to Day Trade
Momentum is the rate at which a stock or commodity price is increasing (or decreasing) on the stock market. If momentum is strong and positive, then the security shows both higher highs and higher lows. Likewise, momentum can be strong and negative. Negative momentum is marked with lower highs and lower lows. No one seems interested in buying, and that keeps dragging the price down.
The exact amount of momentum that a security has can be measured with indicators known as momentum oscillators. A classic momentum oscillator starts with the moving average, which is the average of the closing prices for a past time period, say the last ten trading days.
Then the change in each day’s moving average is plotted below the price line. When the oscillator is positive, traders say that the security is overbought; when it’s negative, they say that the security is oversold.
If a momentum oscillator shows that a security is overbought (the line is above the center line), too many people own it relative to the remaining demand in the market, and some of them will start selling.
Remember, some of these people have perfectly good reasons for selling that may have nothing to do with the underlying fundamentals of the security, but they are going to sell anyway, and that brings the price down. Traders who see that a security is overbought want to sell in advance of those people.
If a momentum oscillator shows that a security is oversold (the line is below the center line), the security is probably too cheap. Everyone who wanted to get out has gotten out, and now it may be a bargain. When the buyers who see the profit opportunity jump in, the price goes up.
The trend is your friend — until the end. Although great reasons exist to follow price trends, remember that they all end, so you still need to pay attention to your money management and your stops, no matter how strong a trend seems to be.
Given that most trends end — or at least zig and zag along the way — some traders look for securities that fit what they call the 1-2-3-4 criterion. If a security goes up in price for three consecutive days, then it’s likely to go down on the fourth day.
Likewise, if a security has fallen in price for three days in a row, it’s likely to be up on day four. Be sure to run some simulations to see whether this strategy works for a market that interests you.