What is Momentum Trading?

Wed Jan 13, 2021, 04:47 pm | by Ashley Hart | No comments

Savvy traders usually have several investment strategies at play, but they’re not all the same. Here’s what you need to know about momentum trading.

Goal of Momentum Trading

Momentum trading aims to take advantage of market volatility. Traders use this strategy to profit from either buying or selling a security when the security is strongly trending. If a security has high momentum, the price will either go up or down a wide range over a short period of time. However, it’s important to keep in mind that every security’s price varies to a certain degree on a normal day. The trick to momentum trading is to watch for strong trends in either direction. You’ll want to take a position in whichever direction that the trend is moving in. So if a security is trending upward, you’d buy it. If it’s trending downward, you’d sell it. 

Most traders will only use momentum trading as a small but important piece of their overall investing strategy. You can only use momentum trading in the short-term, so while it can be a great strategy for savvy traders, you’d also want to have more long-term strategies in place.

To be successful in momentum trading, you must feel comfortable taking on risks. You should also feel confident in your ability to closely monitor trends so that you can buy and sell your positions at the right times. This isn’t a strategy that a casual investor would want to use, but if you can dedicate yourself to monitoring the market and making the right moves, you could end up turning large profits.

Pros/Cons of Momentum Trading

As with any investment strategy, there are pros and cons to consider before you jump into momentum trading. 

Pros

Since momentum trading has you essentially “riding the wave” of trends, it’s an investment strategy that tends to move more quickly than others. This means that there’s a potential to make high profits over a short period of time. 

Momentum trading is also a unique strategy in that it’s more of a logical method than an emotional one. It’s no secret that the stock market can be heavily influenced by the news and how investors generally react to news. Say, for example, that a major company is facing backlash over a controversial issue. This may drive investors to turn away from the company, thus hurting their stock market performance. Momentum trading is not a strategy that relies on emotional reactions. Instead, this is a strategy that allows you to follow the emotions of other investors and predict how their reactions will affect the stock market. The thrill of making those predictions can be quite exciting and fun for some investors.

Cons

Even though there are certainly benefits to momentum trading, there are also downsides that you need to consider. First of all, since momentum trading relies so heavily on getting the timing just right, there’s always the risk of buying at the wrong time or predicting incorrectly. This can lead to substantial losses instead of the quick gains that momentum trading is used for. 

Another cost-factor to consider is the fees that come along with trading. Since you’re only buying stocks to sell them again in a short period of time, this means that you’ll be paying your broker’s commission fees more often than if you were using some alternative strategies. This only applies if you use a broker that still has commissions.

Momentum trading can take up a great deal of your time. This isn’t an investment strategy that allows you to “set it and forget it,” unlike some alternative strategies. Momentum trading requires you to monitor market details every single day, and in many cases, frequently throughout the day. If you don’t keep an eye on the market, you may miss out on the right time to buy or sell your security. Some momentum traders may also spend a good deal of time watching or reading the news to help predict what other investors may do to change the market.

You should also consider that the overall condition of the financial market can impact the success of momentum trading. This strategy works best in a bull market, meaning that prices are on the rise or expected to rise. If you find yourself trying to use momentum trading in a bear market (when prices are declining for a prolonged period of time), there is much less of a chance of making large profits from the strategy. That’s why if you do decide to use momentum trading, you should make sure it’s not the only strategy you’re losing. 

Momentum Trading Strategies

Trading in the Stock Market

Momentum trading is a popular day trading strategy on the stock market. You can use tools such as stock scanners to browse the entire market, looking for the stocks that have momentum. When trading in the stock market using momentum trading strategies, you’ll want to have certain criteria in mind.

For example, you might want to only consider stocks with a float of under a certain threshold. A float is the number of shares that are free to trade in the open market. You might also have certain criteria based on the daily charts, including the stock’s moving averages and resistance. If you’re using stock scanners, you should be able to set alerts that will notify you as soon as a stock meets your criteria. Instead of monitoring the market continuously, you can rely on these alerts to let you know when it’s time to make a move.

Trading in Futures Market

There are a couple of momentum trading strategies that you can use in the futures market. 

Pullback strategy: The pullback strategy is a simple momentum trading strategy. It’s what you think of when you think of momentum trading — the principle is to look for the futures market’s trend to shift, and then jump in at that opportunity. There are a number of tools that you can use to participate in this strategy, including trend lines and moving averages. 

Breakout strategy: This strategy is generally riskier because it relies more heavily on making accurate predictions instead of jumping in immediately. A breakout is when a stock’s price moves outside a defined support or resistance level. Sometimes prices may open beyond a support or resistance level, but then end up back within the prior trading range before the trading day is over. It’s important to be careful when using the breakout strategy, because if you act too quickly, you may find that the prices did not move the way you expected them to, leaving you stuck with a security that you cannot move in the way you’d hoped. A savvy momentum trader might wait until the trading period is about to close to see where the prices have ended up before making their move. 

Final Thoughts

Momentum trading can be an enjoyable and lucrative strategy for some investors, but it’s not for the faint of heart. If you’re a beginner,  you may not want to try this strategy quite yet, as it can be a risky and costly venture. However, if you understand the market and enjoy monitoring and analyzing it, you may want to add momentum trading to your overall investment strategy.