What Is Momentum Trading and How to Use It?

What Is Momentum Trading and How to Use It?

Momentum trading is an extremely active trading style mostly used by experienced investors. During momentum trading, the investors usually make short-term calls driven by quick price surges. These might be fueled by different reasons, but the principle is the same – buy just before the big growth, then sell and run away with gains.

As you imagine, it’s a somewhat risky endeavor partly because you can just as easily lose your chance and partly because it implies riding volatile dangerous trends. So, what is it?

What is Momentum Trading?

The standard trading most people have in mind relies on long-term investments, sometimes lasting up to a year. It’s a legitimate technique, of course, but momentum trading allows you to theoretically earn money in a much shorter span.

The usual scheme works like this:

  1. Look for a promising trend
  2. Open a position
  3. Wait for the price to surge
  4. Close just as it’s going down.

Traders who adhere to this principle take big risks. They don’t just buy low and wait for the stock to rise, they buy high and wait for it to grow even more. Obviously, not every trend will start growing just because you entered it. There are certain requirements.

Requirements for Momentum Trading

The ideal trends for momentum stocks for this sort of trading are characterized by several features:

  1. Large volumes of trading;
  2. Big volatility (market risks, basically)
  3. Sizeable liquidity (a lot of participants)
  4. Strong positive trend.

The momentum traders specifically target these trends and enter them while they are still strong. Alongside that, they keep an eye out for news, events, and promising shares. An even better situation for a momentum investor is when the situation is just starting to develop. 

If you can hop on this ride and leave before it literally loses momentum, you’ll be in a very good spot. Sometimes, the timeframe of that is shorter than an hour. You hop onto the strong trend and leave mere 20 minutes later. That’s how these people usually work. Of course, if you have a sharp eye, you already noticed a few problems here.

Strategy

The logic behind this momentum trading strategies is that surely a lot of people will enter the trend when it’s starting to gather speed. However, there’s no telling for how long this growth is going to last. As soon as the price grew enough, you need to act.

The growth is usually quite intense, although it’s often not too big in the end. To counter that, the usual practice is to commit more capital than usual to this one short-term position, then go over to the next one just as quickly. The combination of size and speed usually produces results if you can play this strategy effectively.

As you understand, risking a lot of money in the short term can negate your profits and just as easily turn them into losses if you aren’t attentive enough.

What Is Momentum Trading and How to Use It?

Yes, funny enough, attention is key here. The momentum can only last minutes, so you should be all eyes when trading this way. 

Experience is also of huge player. Candlestick charts very often form into patterns – selective recurring shapes that usually culminate in the same outcome. Learning them is no use, but if you encountered them several times before, you’ll know what to expect.

As you remember, knowing when a liquid and popular stock is likely going to enter a stage of extreme growth is one of the most promising situations in trading. There are several ways you can anticipate this:

  1. Being an experienced trader. It doesn’t depend on your decisions, obviously. If you are already a knowledgeable investor, you’ll be able to estimate when a trend is entering a promising bullish trend. This sort of thinking doesn’t bear fruit all the time, but you’ll be more prepared for a potential boom than most.

Note that if you pay enough attention to the charts, you’ll be able to leave the sinking ship before it’s too late even if your estimations don’t prove true. In this style of trading, it’s important to be ahead of the pack because if you enter too late, it might be too late to make a profit.

  1. Be aware of the news. It’s a territory of news trading – an extremely beneficial style of trading that basically requires you to listen to the news and developments in the economic world, as well as understand how they might affect the market.

Most people do a bit of both. Since this sort of trading allows for a faster pace, you can react and commit to the promising trends faster than most traders. It’s a very sizeable advantage.

You should also make sure to leave the failed attempts. Don’t wait until your investment enters a good phase again – it’s not worth the wait. There are thousands of other liquid and rapidly growing markets that can be harvested, so waiting is not an option.

Instead, close these positions and redeem what funds you can, and then put them into a better stock. If done skillfully, your failed attempts can be redeemed.

Common risks

Most risks with momentum trading are associated with the usual parameters – the spreads and the volatility. In this case, they are even more relevant, seeing how one of them is part of what makes this strategy so profitable.

Remember: you’ll have to choose popular stocks with a large trading volume. This ensures that you can sell or buy shares exactly when you want to.

The volatility is particularly important in this context because that’s what makes prices grow so fast. It reflects how risky the market is because it’s a parameter of how much and how fast the value can change. If you enter a positive trend, then it’ll be able to change very quickly and not in the negative direction – at least not at first.

It’s also able to reverse just as easily, so it’s wise to leave the trend as soon as it’s starting to lose speed. You can wait until the first bearish candlestick to sell on a peak, but it’s dangerous. If you’re new to that, it’s better to bail early.

Understandably, since a lot of people are buying and selling simultaneously, you’ll experience some very wide spreads. It means you can very easily lose a lot of your gained money if the spread difference was harsh for that particular second.

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author

Carolyn Huntington is an economist, professional trader, and analyst. She made her first big deal in her student years with a profitable investment in Facebook stock. Now the total experience of her trade is 18 years. Over the years of trading, Carolyn has developed its own strategy that allows even those who have never traded on the stock exchange before to earn money. She also creates market forecasts and advises major shareholders, compiles investment portfolios, and teaches how to work with automated advisors.

telephone: 503-547-5192