In a momentum trade, an investor will time his or her buys and sells based on how the stock is moving. Unlike many other types of traders and analysts who focus on a company’s fundamentals. Momentum traders are most interested in what is going on in the news. They are looking for stocks which move by a high percentage or volume.
Requirements for success as a momentum trader
Momentum traders need high levels of focus and attention. They must remain steadfast when they have caught momentum in the right direction. In this way, these traders exercise huge degrees of discipline.
Most momentum traders are day traders, meaning that their moves happen very quick. Timing is thus crucial to the success of a momentum trade. The broader category of momentum trading, there are at least two smaller subgroups. Technical-based momentum traders and event-based (or fundamental) momentum traders.
Technical-based momentum trader
These traders make decisions based on the market as being either high or low than expected. They use technical analysis to determine these assessments. If a trader finds that the market prices are higher than they believe they should be. They will short a stock now and buy later. If they believe the prices are lower than they should be, they’ll buy now and short later.
Event-based (fundamental) momentum trader
This trader bases his or her decisions on market volatility which results from news across a trading day. When a big piece of news hits the airwaves, the market reacts with an increase in volatility. This period of heightened volatility often lasts for several hours. Momentum traders may try to make money through a series of rapid trades in the areas which are fluctuating.
Strategy and techniques of momentum traders
Momentum traders focus on more than trends in stocks. They look to stocks which show a strong move in a given direction, with high volume and over a distinct time. They then buy stocks which have been trending in this direction. Aiming to capture waves of investor enthusiasm which have prompted trading.
Traders using this strategy draw their data and analysis from the following sources.
- Daily watch lists
Momentum traders often follow a daily watch list of stocks and are always on televisions. Message boards, brokerage apps, and more.
- Volume as indicator
Traders making decisions based on momentum follow trade volumes as a major indicator. If there are more buyers than sellers and a stock is becoming popular. The price tends to rise, and trading activity is further increased.
- Resistance levels
Once they’ve identified a stock that is trending, the trader will look for companies with stocks testing their resistance levels. If a stock breaks a resistance level in either direction, it is a prime candidate for investment.
- Technical indicators
To identify a resistance break, momentum trading looks for technical indicators. Some stock trading programs analyze these trend lines. Momentum traders are less concerned with buying at bottoms and selling at tops. Instead, they make moves based on a price trend after a stock has passed a resistance point. Then sell or short that stock when they have achieved a profit.
- Conservatism as a grounding strategy
Momentum traders have to know when to cut their losses. They look to eke out small profits on a daily basis, but sometimes their momentum trades fail. In this case, it makes more sense to exit a position than to hold onto it in hopes that it will turn around again. Traders who are adept at navigating resistance points can trade with a fair degree of safety. There is always some risk associated with trading.
- Trading times
Usually, momentum traders focus on the first and the last hour of each day’s trading session. In these times, there is a flurry of activity which results in higher volatility. They also close out all their positions by the end of the day. As leaving positions open overnight can result in unexpected changes to momentum.
Discipline is essential for momentum traders. They follow one or two stocks at a time, and they have to react quick. They need to use margin often to generate significant profits. And this amplifies the risk they take on.
One way to determine market momentum is through the Average Directional Index indicator. Readings below 25 tend to show that the market will offer strong pullbacks to start swing trades. while readings above 25 suggest a strong trend with minimal pullbacks. Thus, momentum traders look for ADX levels of 25 or greater.
The reason this trading can be successful is that well-performing stocks do tend to continue to outperform the broader market. The exact reasoning for this is unclear. But it may be because of irrational investor behavior and herd mentalities. Or it could be due to the fact that some of these companies are better-managed than their competitors. In truth, though, momentum traders don’t care about the reasons. They only aim to have the best modes of analysis for recognizing and trading stocks which they feel have enough momentum.
Dangers of momentum trading
There are some particular risks associated with momentum trading. If executed in a proper way, it links in some cases to a type of trading called high probability trading. If a trader happens to enter a position too soon. And it turns out that momentum has not been also achieved, that can be a problem. If the trader closes the position too late, after the saturation point reaches. This minimizes profits. If traders miss news stories, they completely miss out on their investment opportunities.
Momentum trading is also considered one of the more difficult approaches. But the possibility for significant profit is high. Because it tends to be the single greatest factor in a stock’s price movement.
Momentum traders use a short term strategy that aims to profit off of high-volume stocks. These traders look for breakout points in price and then follow them with their trades. They tend to close out of their positions by the end of the day and use margin to help support their gains. It is a spur-of-the-moment trading strategy which requires close analysis and lightning-fast reflexes. so it is a strategy reserved for advanced traders.