Introduction To Momentum Trading

By Jason Van Bergen AAA

In momentum trading, traders focus on stocks that are moving significantly in one direction on high volume. Momentum traders may hold their positions for a few minutes, a couple of hours or even the entire length of the trading day, depending on how quickly the stock moves and when it changes direction. Here we'll look at momentum trading and examine a typical day in the life of this type of active trader.

Reviewing Different Types of Traders
Before we focus on momentum trading, let's review all the major styles of equity trading:

  • Scalping
    The scalper is an individual who makes dozens or hundreds of trades per day, trying to "scalp" a small profit from each trade by exploiting the bid-ask spread.
     
  • Momentum Trading
    Momentum traders look for stocks moving significantly in one direction on high volume and try to jump on board to ride the momentum train to a desired profit. For example, Netflix (Nasdaq:NFLX) surged over 260% to $330 from January to October in 2013, which was way above its valuation. Its P/E ratio was above 400, while its competitors' were below 20. The price went up so high primarily because many momentum traders were trying to profit from the uptrend, which drove the price even higher. Even Reed Hasting, CEO of Netflix, admitted that Netflix is a momentum stock during a conference call in October 2013.
     
  • Technical Trading - Technical traders are obsessed with charts and graphs, watching lines on stock or index graphs for signs of convergence or divergence that might indicate buy or sell signals.
     
  • Fundamental Trading
    Fundamentalists trade companies based on fundamental analysis, which examines corporate events such as actual or anticipated earnings reports, stock splits, reorganizations or acquisitions.
     
  • Swing Trading
    Swing traders are really fundamental traders who hold their positions longer than a single day. Most fundamentalists are actually swing traders, since changes in corporate fundamentals generally require several days or even weeks to produce a price movement sufficient enough for the trader to claim a reasonable profit.

Novice traders might experiment with each of these techniques, but they should ultimately settle on a single niche, matching their investing knowledge and experience with a style to which they feel they can devote further research, education and practice.

Let's begin our exploration of momentum trading.

A Day in the Life of the Momentum Trader
A good way to illustrate momentum trading is to look at a typical day of a momentum trader:

He gets up an hour before the market opens, switches on his computer, goes online and immediately logs into one of the popular trading chat rooms or message boards.

When looking at these boards, our hero focuses on stocks that are generating a significant amount of buzz. He looks at stocks that are the focus of trading alerts based on earnings or analyst recommendations. These are stocks rumored to be in play, and they are anticipated to provide the most significant price movements on high volume for that trading day.

While surfing the web, he will also turn on CNBC and listen for mentions of companies releasing news or positioned to undergo significant movement.

He eyes the morning equity options pages to find stocks with significant volume increases in calls. Any increase in calls written indicates that a price increase or decrease above or below the option premium is expected.

Once the market opens, he watches his initial list of stocks in relation to the rest of the market: Are his stocks going up when the market goes down? Are they significantly increasing in price in relation to the rest of the market? Are they behaving consistently with his expectations based on his pre-market assessment?

He will then narrow his watch list to include only the strongest stocks: those increasing more rapidly on higher volume than the rest of the market, stocks trading contrary to the market and stocks with movements clearly propelled by external factors.

Analyzing the Charts
Next, a momentum trader will analyze the list of stocks he has chosen to focus on by examining their charts. The primary technical indicator of interest is the momentum indicator - the accumulated net change of a stock's closing/ending price over a series of defined time periods. The momentum line is plotted as a tandem line to the price chart, and it displays a zero axis, with positive values indicating a sustained upward movement and negative values indicating a potentially sustained downward movement.

That upward or downward momentum indicator often immediately portrays a breakout for the stock, which means that even a period or two of sustained momentum will propel that stock in the direction of the breakout. While watching the momentum chart, he has his Level 2 screen up, looking for evidence of a push, where bids start to line up (indicated by the presence of market-maker limit orders) and offers start to disappear.

When the trader believes he has identified a breakout, he does not necessarily need to jump immediately into the stock. He is not generally worried about missing the first one or two breakout ticks, but he has his hand on the buy trigger (or sell trigger in the case of a short sale, but a short sale must be done on an uptick) for one of the next momentum periods. And he is generally not too concerned about hitting the bid either, as he will have an easier time getting in at the market price. Then he places a market order.

Momentum Trader: In Position
Once he has entered into his position, the white-knuckle ride and nail-biting begins. Will the stock continue to move strongly in the direction of his momentum line? Or will it immediately change course, proving the momentum chart wrong and perhaps pointing to a trap set by the market maker? Or will the breakout fizzle quickly, providing some limited upside but not enough profit to make the trade worthwhile?

Whether the momentum fizzles almost immediately or continues to build, the trader remains glued to his screen. He is looking for a saturation point, where orders start piling up on the offer and bidding slows or thins at the market price a few levels back on the Level 2 screen. The saturation point does not mean an immediate end to the momentum, but it may signal that the top is near. So the trader sells his position (or covers his position in the case of a short sale) and takes his profits to pack it in for the day or to move on to the next stock on his list.

Note that in the event of a breakout gone wrong, where a stock immediately turns direction and moves against the trader's wishes, a special strategy applies. Far from hoping for yet another reversal to make the stock go his way, this astute trader immediately cuts his losses and sells (or covers) his position. It is often a far better strategy to take a small loss early after a bad trade than to hope for a reversal later in the day. The odds generally ensure that a small loss will turn much larger the longer the trader waits with crossed fingers.

And here's where psychology rules the roost: The astute trader realizes that there will be bad trades that result in losses. Accepting that fundamental fact of trading life helps us manage our money so that trades that go swimmingly will outweigh these losses.

Pitfalls of Momentum Trading
Like all investing - and particularly active trading - momentum trading is not without risk. The pitfalls of momentum trading include:
 

  • Jumping into a position too soon, before a momentum move is confirmed.
  • Closing the position too late, after saturation has been reached.
  • Failing to keep eyes on the screen, missing changing trends, reversals or signs of news that take the market by surprise.
  • Keeping a position open overnight. Stocks are particularly susceptible to external factors occurring after the close of that day's trading - these factors could cause radically different prices and patterns the next day.
  • Failing to act quickly to close a bad position, thereby riding the momentum train the wrong way down the tracks.

The Bottom Line
Because of these pitfalls, momentum trading is fraught with peril that can easily destroy even the most disciplined and knowledgeable trader. However, this style also offers the most potential for significant profit, since rarely any factor inside or outside the market drives a stock as powerfully as momentum. With a proper understanding of the technique, sufficient knowledge of the risks and a willingness to take an occasional loss, momentum trading offers an appealing choice for the aspiring trader who enjoys living on the edge.

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