Unskilled traders flock to momentum markets like moths to a flame. The impulse to buy high and sell higher when a security ramps from one level to another is irresistible. But it can trigger enormous losses because such specialized environments require highly defensive risk management rules, which are often ignored because participants are blinded by the fear they’ll miss the move while everyone else books windfall profits. (For more on this topic, see: Momentum Trading With Discipline).
So, what does it take to prosper with momentum strategies and how easily can we incorporate the risk management techniques we need to keep us out of harm’s way? What sort of securities work best in momentum markets and which technical indicators enable the most reliable entry and exit signals? Finally, what much risk should we take and how long should we engage a vertical rally or sell-off before walking away with our profit or loss?
Most participants fall into the momentum trading in their careers and never try anything else because it shows the greatest potential for rapid wealth creation. However, the greedy eye routinely form fits, seeing a hundred ways that imaginary positions make money while ignoring all the whipsaws, reversals and raids that shake out the majority of weak hands. This risk must be seriously considered, otherwise even the most promising strategy is likely to fail. (For related reading, see: Risk Management Techniques For Active Traders).
Pick The Right Play
When using momentum strategies, stick with liquid instruments. Avoid leveraged ETFs because price movement doesn’t accurately track the underlying instruments, often flashing false technical signals at the worst possible time. Regular ETFs work great as momentum plays but rarely show the emotional intensity of individual securities reacting to news shocks that induce all sorts of market players to take risk.
Liquidity is everything when playing momentum so look for securities that will trade in excess of 5 million shares per day whenever possible. This is a tricky number because illiquid issues can turn over small floats dozens of times per day under the right conditions. Find these plays by scanning for stocks that trade at least 75% of their average daily volume in the first hour or, if not found during market hours, stocks that traded at least five times their average daily volume in that session.
Momentum traders love the "flavor of the day", whether its 3D printing or mountable cameras, but the best plays come through paradigm shifts at well-established companies. These can be new products that capture the public’s imagination or acquisitions that force analysts to throw away their spreadsheets and re-compute profit estimates. Biotechs emit a nearly endless supply of these "expectation shocks", making them ideal choices for the momentum game.
Watch Your Timing
Momentum strategies demand precise timing and strict emotional control. (To learn more, read: The Importance Of Trading Psychology And Discipline). These can be managed by understanding how these plays evolve through three phases:
- New Impulse - A news shock hits, triggering rapid movement from one price level to another. Early momentum players see the action, jump in and are rewarded with instant profits.
- Mature Impulse - The growing supply of momentum traders triggers pullbacks and stop runs that shake out weak hands.
- Climax Impulse – The supply of momentum traders hits an extreme, triggering volatile whipsaws and a major reversal.
This progression tells us that early positions offer the greatest reward with the least risk while extended trends should be avoided at all costs. However, this is exactly the opposite of what happens in the real world, with the last phase printing the highest volume because a) traders don’t see the play until late in the cycle or b) they fail to act until everyone else jumps in. In both cases, late positions routinely incur major losses because they’re aligned with the crowd being targeted by stronger hands.
Moving Average Convergence-Divergence (MACD) offers a useful tool in pinpointing momentum entry and exit. (For more information, read: Trading The MACD Divergence). Advent Software (ADVS) ticks higher, lifting the indicator above the horizontal signal line in January, and enters a rally wave that accelerates into mid-month, adding more than seven points. MACD peaks with the uptrend and rolls over on the first day that price posts a lower low than the prior session. This downturn, in combination with the security pulling back from the top Bollinger Band, waves a red flag that tells momentum traders to take profits or tighten stops.
Momentum Entry and Management
Scale into momentum positions, adding one half or one third after the prior piece eases into a profit. Move your stop to break-even at the same time, adjusting it with each tranche until you’re sitting in a free trade. This is a tougher strategy to execute than you might think for two reasons. First, momentum plays often exhibit wide bid/ask spreads, requiring larger movement in your favor to reach profitability. Second, they grind through wide intraday ranges, exposing stops even when the technicals look perfectly fine. Address this volatility by waiting on scales until price moves far enough that stop running is less likely.
Risk increases the longer you stay positioned in these trades, so choose your holding period wisely. Many momentum strategies are perfectly suited to day trading, jumping in during the first hour, riding the trend through the middle of the day and taking profits in the closing minutes, while other players are finding the setup and paying too much to hold it overnight. If you choose to hold through multiple sessions, reduce position size to allow for greater movement and the placement of stops further away from current action. (For related reading, see: Trading Is Timing).
The best momentum exits occur in dynamic times, when price is moving rapidly into an overextended technical state, often identified by a series of vertical bars on the 60-minute chart. Take profits or tighten stops whenever price pierces the 4th standard deviation of a top or bottom 20-day Bollinger Band. Consider a blind exit when long term technical barriers are hit, like the trendline created by a series of rising highs. Manage multiday position trades using a relative strength indicator, like Stochastics or Wilder's RSI, getting out or tightening stops whenever a crossover signals a change in power from buyers to sellers or vice versa. (To learn more, see: Relative Strength Index And Its Failure-Swing Points).
Array Pharmaceuticals (ARRY) went vertical after reaching a distribution deal with a major drug manufacturer, lifting more than 75% in seven sessions. The momentum impulse crossed the 4th standard deviation on the 5th day of the uptick, signaling caution that demands a quick exit or tight trailing stop. The rally ends in the next two sessions, yielding an extended trading range. Note how this useful band setting also signaled the end of a December breakout.
The Bottom Line
Momentum markets generate high-reward high-risk environments that confound traders until they employ specific risk management practices including careful selection, ideal timing and opportune exits. Once mastered, traders will enjoy a lifetime edge over a restless crowd that mindlessly throws money at these markets, hoping for the big score. (For related reading, see: When Fear And Greed Take Over).