- Momentum trading refers to a style of investing that attempts to capitalize on the continuance of existing trends in the marketplace.
- Momentum trading strategy is often considered useful because it comes with a good risk-reward ratio, has a significant room for profits for early birds and gives the trader an edge as a result of being less efficiently priced.
- Identifying the underlying trend, timing the entry, and placing the correct stop loss are key elements associated with momentum trading.
- Good momentum stocks usually carry strong fundamentals, positive news, high valuation, and positive technical indicators.
- Trend following, momentum oscillation and price action are some of the major momentum trading strategies currently practiced.
If you’re looking to add an extra edge to your stock trading, momentum trading may be for you. In this article, we’ll discuss what are momentum stocks, how to trade them profitably and some of the key strategies involved. We’ll also provide plenty of examples to help illustrate these concepts. So whether you’re a seasoned trader or just getting started, read on for all you need to know about momentum trading!
What are momentum stocks?
If you have no idea what are momentum stocks, you’ve come to the right place. Momentum stocks are those that show an above-average price movement in the market. They are typically driven by a number of factors, such as positive news, strong earnings reports, analyst upgrades, etc. These stocks tend to have strong fundamentals and high valuations.
Momentum trading explained
Now that you know what are momentum stocks, let’s widen the scope of the discussion. Momentum trading refers to a style of investing that attempts to capitalize on the continuance of existing trends in the marketplace. This type of trading can be applied to any timeframe, from intra-day to longer-term swings. Momentum traders seek out stocks that are moving significantly in one direction and ride the momentum until it dissipates.
The purpose of momentum indicators is to track and exhibit market momentum. Simply put, “market momentum” rate of change is a measure of how quickly prices shift. Indicators of momentum attempt to capture the speed with which prices are increasing or decreasing. Because of this, traders who are seeking to benefit from spikes in volatility utilize them for short-term analysis.
A momentum trader strives to initiate transactions when market momentum is strong and to exit trades when momentum is low. When volatility is minimal, prices tend to consolidate into a small range. With enough pressure applied, the price will usually make a large impulsive move, breaking out of the range. Traders that focus on momentum usually do well during this time.
The traders get out of their position when the trend is over and then look for another asset with similar momentum to attempt to duplicate their strategy on. Day traders, scalpers, and other short-term traders who are searching for rapid trading opportunities rely heavily on momentum indicators.
Why indulge in momentum trading?
There are a few reasons why momentum trading can be an attractive strategy. First, when done correctly, it can provide the trader with a solid risk-reward ratio. Second, by its very nature, momentum trading is geared towards catching trends early – and as we all know, the early bird gets the worm! Finally, many momentum stocks are less followed by the broader market and therefore may be less efficiently priced, providing the trader with an edge.
Of course, as with any type of trading, there are also some drawbacks to momentum trading that should be considered. First and foremost is the risk of chasing a stock that has already run up too far, too fast. This can lead to buying at the top and then experiencing a sharp reversal. Second, momentum stocks tend to be more volatile than the overall market, so traders need to be comfortable with a higher level of risk. Finally, momentum trading requires a decent amount of homework and analysis – if you’re not prepared to put in the work, this strategy is probably not for you.
Now that we’ve covered the basics, let’s take a more in-depth look at some of the key concepts involved in momentum trading.
Anatomy of momentum stocks
Momentum stocks are usually companies that have strong fundamentals and are in the news. They tend to be high-growth companies with products or services that are in demand. These companies often have high valuations, but they can also be undervalued.
There are several things you need to look for when trying to identify momentum stocks:
- Strong fundamentals: The company should have strong financials, including revenue growth, earnings growth, and a healthy balance sheet.
- Positive news: The company should be in the news for positive reasons, such as new product launches, partnerships, or expansion plans.
- High valuations: The stock should have a high valuation, as measured by price-to-earnings (P/E) ratio, price-to-sales (P/S) ratio, or enterprise value-to-revenue (EV/R) ratio.
- Technical indicators: The stock should have positive technical indicators, such as rising moving averages or breakouts from previous resistance levels.
Precepts of momentum investing
The precepts of momentum investing are simple:
- Trends exist in all time frames.
- Prices tend to move in the same direction for extended periods of time.
- The key to profitable momentum trading is timing – getting in at the beginning of a move and getting out before it ends.
Main elements to successful momentum trading
There are three main elements to successful momentum trading:
- Identifying the underlying trend,
- Timing the entry, and
- Placing the correct stop loss.
Let’s take a closer look at each of these in turn.
Identifying the underlying trend
The first step in momentum trading is to identify the overall trend in the marketplace. This can be done by looking at price charts on various timeframes. For example, if you’re looking at a daily chart, is the stock in an uptrend, downtrend or sideways range? Once you’ve identified the general direction of the market, you can then begin to look for specific stocks that are starting to move in that direction.
Timing the entry
Once you’ve found a stock that you believe is beginning to move in the direction of the overall market trend, it’s important to time your entry carefully. The best way to do this is to wait for the stock to pull back to a support level and then start moving higher again. This will help confirm that the stock is indeed in a strong uptrend.
Placing the correct stop loss
Another important element of momentum trading is placing the correct stop loss. This will help you limit your losses if the stock reverses direction and heads lower. A good rule of thumb is to place your stop loss just below the most recent swing low. This will help ensure that you don’t get caught in a sudden reversal.
By following these simple rules, you can trade momentum stocks profitably. However, there are a few things to keep in mind.
One is that momentum trading works best in an uptrending market. This is because stocks tend to move in the same direction as the overall market. So if the market is trending higher, you’re more likely to find stocks that are also trending higher.
Another thing to keep in mind is that momentum trading can be risky. This is because you’re essentially buying into a stock at or near its highs. If the stock reverses direction, you could experience significant losses. That’s why it’s important to use stop losses and limit your risk exposure.
Finally, momentum trading works best when used in conjunction with other technical indicators. For example, you might want to wait for a stock to form a bullish reversal pattern before entering a trade. This will help confirm that the stock is indeed in an uptrend and not just experiencing a short-term rally.
Momentum Security Selection Process
In order to find the best momentum stocks to trade, you need to follow a process. This process will help you find stocks that are in a strong uptrend and have the potential to continue moving higher.
Here is a step-by-step guide to finding momentum stocks:
- Find a list of momentum stocks: You can find lists of momentum stocks on financial websites or from brokerages.
- Research the stocks: Once you have a list of momentum stocks, research each one to find the best ones to trade. Look at their fundamentals, news, and technicals.
- Select the best stocks: From your research, select the best stocks to trade. Make sure you have a good reason for buying each stock.
- Enter your trade: Once you’ve selected your stocks, enter your trade. You can buy the stock outright or use options to limit your risk.
- Exit your trade: When you’re ready to exit your trade, sell the stock or options. You can also set a stop loss to automatically sell the stock if it falls below a certain price.
Major momentum trading strategies
There are several major momentum trading strategies that you can use. We will discuss each momentum trading strategy one by one.
- Trend following: This is the most common momentum trading strategy. You simply buy stocks that are trending up and sell them when they start to trend down.
- Momentum oscillators: This momentum trading strategy uses technical indicators, such as RSI, to identify overbought and oversold conditions. You then buy stocks when they are oversold and sell them when they are overbought.
- Price action: This momentum trading strategy looks for specific chart patterns, such as breakouts, to enter and exit trades.
- Volume: This momentum trading strategy uses volume to identify momentum stocks. You buy stocks that are seeing increasing volume and sell them when the volume starts to decline.
Momentum trading entry checklist
Before entering a momentum trade, you should always check the following:
- The stock is in an uptrend: You should only buy stocks that are in an uptrend. This can be confirmed by looking at the trend lines on the chart.
- The stock is not overbought: You should avoid buying stocks that are overbought. This can be confirmed by using technical indicators, such as RSI.
- The stock has breakout potential: You should look for stocks that have the potential to break out. This can be confirmed by looking at the chart patterns.
- The volume is increasing: You should only buy stocks that are seeing increasing volume. This is a sign of momentum.
- You have a stop loss in place: You should always have a stop loss in place before entering a trade. This will help you limit your downside risk.
Momentum trading exit indicators
There are several momentum trading exit indicators that you can use:
- The stock is in a downtrend: You should sell stocks that are in a downtrend. This can be confirmed by looking at the trend lines on the chart.
- The stock is overbought: You should sell stocks that are overbought. This can be confirmed by using technical indicators, such as RSI.
- The stock has broken down: You should sell stocks that have broken down. This can be confirmed by looking at the chart patterns.
- The volume is declining: You should sell stocks that are seeing declining volume. This is a sign of momentum slowing down.
- Your stop loss has been hit: You should sell stocks when your stop loss has been hit. This will help you limit your downside risk.
Major technical indicators used in momentum trading
Moving Average (MA)
In technical analysis, the moving average is an indicator used to represent the average closing price of the market over a specified period of time. Traders often make use of moving averages as it can be a good indication of current market momentum.
The two most commonly used moving averages are the simple moving average (SMA) and the exponential moving average (EMA). The difference between these moving averages is that the simple moving average does not give any weighting to the averages in the data set whereas the exponential moving average will give more weighting to current prices,
The main purpose of the moving average is to eliminate short-term fluctuations in the market. Because moving averages represent an average closing price over a selected period of time, the moving average allows traders to identify the overall trend of the market in a simple way.
Another benefit of the moving average is that it is a customizable indicator which means that the trader can select the time-frame that suits their trading objectives. Moving Averages are often used for market entries as well as determining possible support and resistance levels. The moving average often acts as a resistance level when the price is trading below the MA and it acts as a support level when the price is trading above the MA.
There are 3 ways in which trader’s use the moving average:
- To determine the direction of the trend
- To determine support and resistance levels
- Making use of multiple moving averages
The Moving Average Convergence Divergence (MACD) is a technical indicator which simply measures the relationship of exponential moving averages (EMA).The MACD displays a MACD line (blue), signal line (red) and a histogram (green) – showing the difference between the MACD line and the signal line.
The MACD line is the difference between two exponentially levelled moving averages – usually 12 and 26-periods, whilst the signal line is generally a 9-period exponentially smoothed average of the MACD line.
These MACD lines waver in and around the zero line. This gives the MACD the characteristics of an oscillator giving overbought and oversold signals above and below the zero-line respectively.
Relative Strength Index, or RSI, is a popular indicator developed by a technical analyst named J. Welles Wilder, that helps traders evaluate the strength of the current market.
RSI is similar to Stochastic in that it identifies overbought and oversold conditions in the market.
It is also scaled from 0 to 100.
Typically, readings of 30 or lower indicate oversold market conditions and an increase in the possibility of price strengthening (going up).
Some traders interpret that an oversold currency pair is an indication that the falling trend is likely to reverse, which means it’s an opportunity to buy.
Readings of 70 or higher indicate overbought conditions and an increase in the possibility of price weakening (going down).
Some traders interpret that an overbought currency pair is an indication that the rising trend is likely to reverse, which means it’s an opportunity to sell.
In addition to the overbought and oversold indicators mentioned above, traders who use the Relative Strength Index (RSI) indicator also look for centerline crossovers
A movement from below the centerline (50) to above indicates a rising trend.
A rising centerline crossover occurs when the RSI value crosses ABOVE the 50 line on the scale, moving towards the 70 line. This indicates the market trend is increasing in strength, and is seen as a bullish signal until the RSI approaches the 70 line.
A movement from above the centerline (50) to below indicates a falling trend.
A falling centerline crossover occurs when the RSI value crosses BELOW the 50 line on the scale, moving towards the 30 line. This indicates the market trend is weakening in strength, and is seen as a bearish signal until the RSI approaches the 30 line.
Key factors to keep an eye on when momentum trading
There are several factors that you need to keep track of when momentum trading:
- Support and resistance: You need to identify key support and resistance levels on the charts. These levels will act as your entry and exit points.
- Trend lines: You should also identify trend lines on the charts. These will help you confirm the direction of the trend.
- Volume: Volume is an important indicator in momentum trading. A stock needs to have enough volume to move in the desired direction.
- Technical indicators: You can use technical indicators, such as moving averages and Relative Strength Index (RSI) as discussed above, to help you identify momentum stocks.
When you are momentum trading, you need to manage your position size properly. If you trade too large of a position, you will likely incur large losses. Conversely, if you trade too small of a position, you will likely miss out on profits.
As a general rule, you should risk no more than 1% of your account on each trade. This will allow you to survive a string of losses and still have enough capital to trade with.
If you are new to momentum trading, it is important to start with small position sizes and to always use stop losses. As you become more comfortable with the strategy, you can gradually increase your position size. Remember to always trade with discipline and to follow your plan.
How to utilize momentum trading strategies profitably?
There are several things you need to do in order to trade momentum stocks profitably:
- Have a plan: You need to have a well-defined investment plan before you start trading. Otherwise, you will likely make mistakes that will cost you money.
- Use stop losses: You should always use stop losses to limit your downside risk on each trade.
- Take profits: You should take profits when the stock reaches your target price. There is no need to wait for the perfect moment.
- Be patient: You need to be patient and wait for the right opportunity before entering a trade. Jumping in too early can often lead to losses.
- Be disciplined: You need to be disciplined and follow your plan. Otherwise, you will likely make mistakes that will cost you money.
How to analyze momentum trading results?
There are several things you need to do in order to analyze your momentum trading results:
- Look at your win rate: You should aim for a win rate of 50% or higher. If your win rate is below 50%, you need to improve your trading strategy.
- Look at your average profit/loss: You should aim for an average profit/loss of 2% or higher. If your average profit/loss is below 2%, you need to improve your trading strategy.
- Look at your risk/reward ratio: You should aim for a risk/reward ratio of 1:2 or higher. This means that for every $1 you risk, you should aim to make $2 in profit. If your risk/reward ratio is below 1:2, you need to improve your trading strategy.
Frequently Asked Questions
What are momentum stocks?
Momentum stocks are stocks that are moving up or down in price very rapidly. These stocks are typically associated with high levels of trading activity and large price changes.
What is momentum investing?
Momentum investing is an investment strategy that seeks to capitalize on stocks that are experiencing rapid price changes. Momentum investors buy stocks that are rising in price and sell them when the momentum starts to slow down.
What is the Ideal Entry Timing?
The ideal time to enter a momentum trade is after the stock has made a breakout. This can be confirmed by looking at the chart patterns.
What is the Ideal Exit Timing?
The ideal time to exit a momentum trade is when the stock is in a downtrend or when it has broken down. This can be confirmed by looking at the trend lines on the chart.
Where do I set my stop when momentum trading?
You should always set your stop loss at a level that will minimize your downside risk. This will help you protect your capital in case the stock reverses direction.
What is the best time of day to perform momentum trading
The best time of day to trade momentum stocks is during the market hours. This is when the most liquidity is available and the prices are more likely to move.
What are some common momentum trading mistakes to avoid?
Some common momentum trading mistakes include not having a stop loss in place, not managing your risk, and chasing losses.
What are the qualities of a successful momentum trader?
There are several qualities that are important for momentum traders:
- They have a well-defined trading strategy: A successful momentum trader needs to have a well-defined trading strategy. They need to know when to buy and sell stocks.
- They are disciplined: A successful momentum trader needs to be disciplined. They need to follow their trading plan and not let emotions get in the way of their trading.
- They are patient: A successful momentum trader needs to be patient. They need to wait for the perfect moment to enter a trade.
Momentum trading can be a profitable strategy if it is done correctly. However, there are several things you need to do in order to be successful. First, you need to have a well-defined investment plan. Second, you need to use stop losses to limit your downside risk. Third, you need to take profits when the stock reaches your target price. Fourth, you need to be patient and wait for the right opportunity before entering a trade. Fifth, you need to be disciplined and follow your plan. If you can do all of these things, you will likely be successful in momentum trading.