Momentum Trading Strategy Explained

In football, you’ll often see a team go to a no-huddle offense when they consistently move the ball against the opponent’s defense. The offense has momentum, so they want to move quickly and not allow the defense to get set properly. Frequently, the offense rides this wave of momentum down the field without needing any overly complex play calls.

When it comes to investing, you’ll want to think like a no-huddle QB when trying a momentum stock trading strategy. Momentum trading requires quick action since you’re attempting to ride the trend wave up, but get off when the wave inevitably peters out. Momentum traders must know how to read stock chart patterns and have the right tools at their disposal to manage their trades.

What Is Momentum Trading?

Momentum trading is a stock trading strategy where traders buy stocks trending upward and sell stocks trending downward. The theory behind the strategy is similar to the concept of momentum itself — bodies in motion tend to stay in motion; bodies at rest tend to stay at rest. 

According to momentum traders, stocks with strong upward price pressure will likely continue rising until something happens to reverse the momentum. Likewise, stocks with downward price pressure will continue declining. The goal of a momentum trader is identifying these trend changes early and entering (and exiting) a position at the ideal time. Most momentum traders use stock market indicators to help in narrowing down potential entry and exit points.

Elements to Consider in Momentum Trading

Momentum traders need to have a solid understanding of a few market factors that drive this type of strategy.

1. Market Volatility

Volatility isn’t something all traders seek, but momentum traders looking for short-term trends must embrace some level of it. Stocks with minimal volatility generally won’t offer the opportunity to capitalize on market volatility that momentum traders are looking for.  

2. Volume

You can’t have volatility without volume, so momentum traders keep a close eye on these numbers to anticipate a sharp move. Stocks with lots of shares being traded are ideal for momentum traders for two reasons — volume creates volatility volume creates volatility and volume also provides liquidity (which allows for more precise entry and exit points).

3. Time Frame

Time horizon is an important factor for investing, but momentum traders have much different time frames than long-term investors. Momentum traders especially must be insensitive to time horizons since trades are often measured in minutes or hours instead of weeks or months.

Factors to Consider For Momentum Trading

Consider these steps to develop a momentum stock trading strategy.

1. Study Momentum Trading Techniques

1Momentum trading isn’t a static strategy and many traders prefer certain technical indicators to others. The important thing is to understand the different aspects of each cornerstone. Can you identify bearish candlestick patterns? Are you familiar with concepts like support and resistance? Momentum trading techniques can be used in different ways, but all require a strong proficiency in technical analysis.

2. Identify the Asset Class You Want to Trade

Momentum trading can be used across sectors and asset classes, so you can stick with the assets you’re most comfortable with. If you have expertise in biotech stocks, momentum techniques can be used in that sector. Prefer ETFs to stocks? Momentum strategies can have a place there. 

3. Find securities trading at preferred levels

Let’s say you’ve determined you want to use momentum to trade stocks. Consider building a list of potential trade targets, like stocks or exchange-traded funds (ETFs) trading near their 52-week highs (or lows) or stocks where a recent price trend has been broken. Narrow down your list of targets or sort them based on potential.

4. Devise an entry/exit strategy

Since momentum time frames are often short, proper entry and exit points are critical for managing trades. Momentum traders aim to enter the trend wave before the majority of the market realizes, so early positioning is crucial. Knowing when to exit with a potential lost is also critical.

Momentum Trading Indicators

Momentum traders seek to identify the trend before the majority of the market; otherwise, they can’t take full advantage. To find the trends before the crowd, technical indicators are often used to find stock chart patterns. Here are a few momentum trading indicators to consider.

1. Stochastic Oscillator

The stochastic oscillator is a momentum stock market indicator that compares closing prices to a range of highs or lows to identify potentially overbought or oversold stocks.

2. Moving Average Convergence Divergence (MACD)

The MACD is a technical indicator that uses two different moving averages in conjunction to identify trend changes. When the signal line is crossed, it could be evidence that the current price trend appears to be weakening.

3. Relative Strength Index (RSI)

RSI is another trend-following indicator that doesn’t just measure price movements, but the speed of those price movements. In general, an RSI over 70 is considered an overbought stock; under 30 is considered oversold.

Potential Advantages of Momentum Investing

There are several potential advantages of momentum investing that make it an attractive strategy for investors. Let's explore some of these advantages further.

• The potential for short-term returns:  Momentum trading can be potentially profitable in a relatively short amount of time if executed correctly. 
• Embracing volatility: Volatile markets often create overanxious traders, but momentum strategies allow experienced and advanced traders to potentially capitalize on market volatility.

Risks in Momentum Investing

Despite its potential benefits, momentum investing also carries a number of risks that investors should be aware of.

• Considerable risks: Momentum traders try to predict future price movements based on the recent actions of other market participants. This is often not a reliable method as a stock's price can be influenced by a variety of factors like a new press release or another fundamental development. 
• No guarantees: Momentum trading uses technical analysis to identify potential trend changes, but false alarms are common and not every seemingly ideal stock chart pattern will result in the predicted price move.
• High turnover rate: Momentum traders are entering and exiting positions quickly, which could cause transaction costs to increase if commissions or high spreads come into play.
• Takes time to learn:  The strategies may be straightforward, but momentum trading takes time to fully grasp because so many ideal setups result in false alarms.

Momentum Trading: Simple to Understand, Difficult to Master

Momentum trading is equal parts art and science since both technical analysis skills and market feel are required for success. Even the best momentum traders won’t have a high success rate, and losers must be dealt with quickly. This strategy flies in the face of the typical “buy low, sell high” market mentality, which makes momentum trading hard to master. But it's still one of the better short-term trading strategies available to day traders.

Frequently Asked Questions