To understand the meaning and functionality of momentum traders it is necessary to know what “momentum” actually implies and its interpretation in regard to trading.
Definition of momentum
The Webster’s Dictionary defines momentum as…..
“the strength or force gained by motion or through the development of events.”
Definition of momentum traders
These traders are looking for acceleration in a stock's price, earnings, or revenues. The traders will then often take a long or short position in the stock with the hope that its momentum will continue in either an upward or downward direction. This strategy relies more on short-term movements in price rather than fundamental particulars of companies, and is not recommended for novices.
Therefore momentum traders trade stocks that are moving significantly in one direction on high volume. The length of time for which momentum traders hold their position in a trade depends on how quickly the stock is moving.
Momentum traders are truly a unique group of individuals. Unlike other traders or analysts who dissect a company's financial statements or chart patterns, a momentum trader is only concerned with stocks in the news. These stocks will be the high percentage and volume movers of the day.
Do not confuse momentum stock trading with trend trading, which is more commonly practiced.
Requirements for successful momentum traders
To be a successful momentum trader, you must have the mental focus to remain steadfast when things are going your way and to wait when targets are yet to be reached. Momentum trading requires a massive display of discipline. This makes short-term momentum trading one of the more difficult means of making a profit.
Momentum trading is performed as a day-trading function and can happen relatively fast; therefore time and timing is extremely important.
Successful momentum traders require a special combination of both technical and fundamental (event-based) analysis.
- Technicals-based momentum trader
Technicals-based momentum traders make trading decisions based on their perception that the market is higher or lower than expected.
Technical analysis is the prediction by a momentum trader of a certain financial instrument being temporarily:
- higher than it should be, in which case the momentum trader can make money by shorting now and buying later; or
- lower than it should be, in which case the momentum trader can make money by buying now and shorting later.
- Event-based (fundamental) momentum traders
An event-based or fundamental-based momentum trader makes trading decisions based on market volatility resulting from news or incidents happening in the course of a trading day.
When the news breaks out, the market will usually become very volatile. The markets for affected stocks and other financial instruments generally swing a lot, starting the moment the news comes out and potentially lasting for a few hours. During this time, momentum traders try to make money making very rapid trades based on the values of those financial instruments fluctuating wildly. A delay of seconds to minutes, as is common in traditional online trading, would therefore not be acceptable to such traders.
Remember: Stocks do not trade on technical analysis and business fundamentals alone. Financial worries, dreams, greed and fear are often the driving factors in investing. Momentum trading strategies attempt to flush out the stocks that are moving because of these factors.
Momentum trading strategy
Momentum trading is more than identifying which way a stock is trending; it is a trading strategy that focuses on stocks or other trading instruments that are showing a strong move in a particular direction, usually on high volume, within a specified time period.
The core strategy of momentum investing is to buy stocks that have been trending in one particular direction, frequently taking the form of buying a new high. Momentum investors aim to capture the waves of enthusiasm that can send stocks blasting higher for extended periods of time.
Momentum trading techniques
- Daily "stock watch list" - Momentum traders will typically have a daily "stock watch list" and stay in tune with daily news via television, message boards and websites.
- Volume as an indicator - The momentum trader uses volume as a primary indicator. When a stock becomes popular for whatever reason, and there are more buyers than sellers, the stock price tends to rise, also increasing trading activity.
- Testing resistance levels - After that, momentum traders look for a stock that is testing its resistance levels. If a stock is just making a lot of sound and fury, signifying nothing, a momentum trader will look elsewhere. Once a stock breaks a resistance level - either up or down - it comes into play for a momentum opportunity.
- Technical indicators - Momentum trading seeks out technical indicators of a resistance break. Many stock trading software programs show these trend lines for you automatically. Momentum traders do not attempt to buy at bottoms and sell at the top - rather, they jump on a price trend after a stock has clearly breached a resistance point and then either sell or short the stock when they have locked in sufficient profits. The greater the volume of trades in a stock, the less probability that the price momentum will reverse and a loss will occur.
Cutting losses short and letting profits run - The chief challenge in momentum trading comes down to knowing when to cut losses. Traders really seek to eke out small profits in percentage terms on a daily basis. If a trade starts to reverse, the short time horizon of the strategy makes it so that it's more sensible to exit a position once it starts going negative in order to limit losses over the long term. Luckily, resistance breaks with high volume; so long as momentum traders gets into the trade before the saturation point, they are generally relatively safe trading plays in most markets. When there is a change in price movement, the trader needs to have a pre-established strategy that leads to a quick exit from the stock position. However, once the trend establishes in the other direction the trader can trade the stock again. Trading momentum stocks works in both directions.
Traders don’t make money-picking pairs, but rather by cutting losses short and letting profits run. And more importantly, they meet investment objectives through the judicious use of position sizing.
- Conservatism is the key - Getting in and out of the trade before the saturation point arrives is a significant challenge. The saturation point is the point at which buy or sell orders start significantly to outnumber those on the opposite side of the trade. Naturally, this point can be difficult to predict, and it's somewhere between luck and art for a trader to consistently avoid being caught in a saturated price movement. Conservatism helps momentum traders to avoid this more often. It helps to have a ballpark estimate of acceptable gains and allowable losses target for every trade to prevent emotional reasoning from interfering with trading efficiency.
- Trading times - Momentum traders will limit the times they trade to the first and last hour of the day trading session. This is due to the increased volatility that takes place during these two time slots. The most dangerous time zone for momentum traders is during lunch (12 - 2pm), when volume dries up and the moves are choppy to flat. Many seasoned momentum traders have learned to respect this time zone as a result of a trading blunder.
- Closing out trades - All positions, even the bad ones, must be closed by the end of the day. Failing to close positions at the end of the day and allowing them to "ride" overnight can make them susceptible to many external and uncontrollable factors, including very different trading patterns the next day.
- Discipline - Momentum trading is a strategy that requires an extraordinary amount of discipline. Successful traders can really only afford to pay attention to one or two stocks at once, as they need to be able to react to changes in the market with lightening rapidity. Many traders need to use margin in order to make significant profits, which magnifies the risks and increases the importance of stop-loss orders and other protective trading methods. Momentum trading falls somewhere between technical analysis trading and trend following as it relies on skills developed by both strategies.
Determining the momentum of the market
One method that momentum traders will use to tell if the market is offering nice pullbacks or when it will trade off of momentum is by checking the Average Directional Index (ADX) indicator.
- Readings below 25 indicate that the market will offer nice pullbacks to initiate swing trades.
- Readings above 25 indicate a strong trend - pullbacks will be shallow or nonexistent.
As long as the ADX indicator is above 25 and sloping up, the market will continue to trade off of momentum. Momentum is lost when it begins to slope down.
There is no such thing as a perfect technical indicator, but the ADX does a good job of telling the momentum trader the current strength of the trend being encountered.
Trading momentum stocks
Trading momentum stocks works for the basic reason that well-performing stocks tend to continue to outperform the rest of the stock market. Theorists argue as to whether this phenomenon is due to irrational investor behavior or whether these stocks are of better-managed companies. For the trader or investor trading momentum stocks, the theory does not matter. What matters is having an efficient system of stock market analysis for recognizing and trading stocks that seem to have momentum.
Trading momentum stocks involves generating software trade signals by following current market calculations, moving averages and channel breakouts to understand market direction. Because traders do not care what the underlying reason is for the stock price movement, they need to have a predetermined set of rules for exiting a trade if the market reverses.
High probability with low risk
When momentum trading is executed properly with a tried and tested trading plan and proper risk control, it displays a trading method that is often referred to as High probability trading.
Momentum trading can be very profitable when risk is handled properly. Stop loss orders should be highly considered to manage risk as part of a successful momentum trading plan.
Pitfalls of momentum trading
There are several situations that a momentum trader needs to aware of:
- 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
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 there is rarely any factor inside or outside the market that drives a stock as powerfully as momentum. With a proper understanding of the technique, sufficient knowledge of the risks, and willingness to take an occasional loss, momentum trading offers an appealing choice for the aspiring trader who enjoys living on the edge.
Momentum trading is a short-term trading strategy that looks to profit from high-volume moves in a certain stock's price. So momentum traders look for breakout points in a stock price and then follow them with their trades either on the up or down side, looking to accrue profits from mass movements in stock price. Most traders close out of their positions by the end of the day, as they make extensive use of margin to finance their gains.
Momentum trading of stocks is for the intermediate or advanced trader. Momentum trading of stocks is a spur of the moment trading strategy. Utilize trading tactics to project market inertia and weigh the momentum of the trade. Remember, you need to have an understanding of the stock market before proceeding to learn momentum trading.
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