Momentum Trading: More Than Timing The Market
Momentum trading is one of the simplest forms of trading. While it takes some technical analysis to spot trends, the idea of momentum trading is to do what makes sense. If a stock is falling, short it; if it’s rising, take out a long position. Traders follow the momentum of a security and trade in tandem with the trend.
Momentum trading isn’t necessarily day trading or swing trading. Momentum traders aren’t concerned about time in a position. Instead, they’re concerned about the culmination of the pattern or a reversal of the trend. And while it may seem like momentum investors are “following the crowd,” there are strong rules governing momentum trading.
“Buy High, Sell Higher”
This phrase was coined by the original momentum investor, Richard Driehaus. He argued that the traditional strategy of buying low and selling high was inefficient. The market can take an indeterminate period of time to reevaluate an underpriced security. Instead, he pushed for buying securities that showed strong momentum, then selling them at a higher peak.
Momentum investing is sometimes referred to as “let it ride” investing. The concept comes from cutting losses to minimize them and reinvesting in securities trending higher. Think of it as a continual rebalancing of a trader’s portfolio. The idea is to have a consistent, revolving group of stocks on the uptrend.
Momentum Traders Are First-In, First-Out
While it might seem like momentum traders are following the pack, it’s arguable that they’re on the cusp of trends. Technical analysis is crucial for momentum trading. Traders who can spot pattern formations will be first in to a position as that pattern takes shape. Likewise, they’ll know where to exit a pattern before momentum swings.
This first-in, first-out approach means traders minimize risk and losses, and compound the gains on momentum. And, because entry and exit are the product of pure technical analysis, momentum traders avoid the headaches that come from emotional decisions.
The Risks of Momentum Trading
Momentum trading comes with a broad range of risks. And while there are risk control methods, traders need to understand how this strategy fares in the face of volatility. Some of the biggest risks of momentum trading include:
- Pattern disruptions and false patterns caused by volatility. Problems with the pattern can result in premature entry or exit of a position.
- Overlooking reversal indicators that cause a pattern to break in the wrong direction. Reversals signal the end of momentum and can incur losses for momentum traders.
- Swing trading and buy-and-hold momentum investing differ from momentum trading. Momentum traders shouldn’t hold a position overnight.
- Failing to close a position at a loss can result in more losses. The spirit of momentum investing is to close losers early and capitalize on new momentum elsewhere.
Momentum traders need to have sound confidence in their technical abilities. That means the self-control to take losses and the foresight to judge entry points. There are also risk control strategies available to momentum traders.
Risk Control Strategies
To mitigate risk, momentum traders need to be diligent in technical evaluation. Understanding the fundamentals of a stock’s momentum is the key to playing that momentum. For most traders, this means consistent charting to verify the formation and culmination of a trend pattern.
There are also several other simple ways to control and mitigate risk. Some of the simplest hedges to consider include:
- Open positions early in the day. This aligns with the “first-in, first-out” mantra of momentum traders. Especially for intra-day traders, the earlier on to a pattern you are, the larger the capitalization prospects of its momentum.
- Exit as reversal patterns form. At the first sign of a reversal formation, momentum traders need to adjust their target price and stop-loss levels, and prepare to exit before momentum swings.
- Trade against emotion. Many traders make emotion-driven trades that can drive up the price of a security. Momentum traders need to recognize when emotion has overtaken technical assessment and take profits before the price regresses.
- Observe metrics. The Relative Strength Index (RSI) is a favorite indicator of momentum traders. It shows if a stock is overbought or undersold. Similarly, moving averages filter out noise in a trend to show true momentum.
Above all, momentum investors need a set of sound metrics by which to govern their analysis. Momentum trading is all-technical. Don’t let emotion skew your actions and inject risk into a position. Follow the numbers and trade using data, not impulse.
Momentum Trading vs. Investing
It’s easy to confuse momentum trading and momentum investing. Trading implies much shorter time in a position. Investing is long-term. A momentum trader may ride the price of a security up over the course of a day or two and sell before a reversal. Momentum investors follow larger bullish and bearish sentiment to profit over time—months and years.
The Bottom Line of Momentum Trading
Momentum trading is best-suited for technical investors who have strong analytical savvy. The high rate of trading and time-intensive practice of trend analysis makes momentum trading a full-time job. Investors need to be able to make data-driven decisions without emotional influence. More importantly, they need to have the confidence to be first-in and first-out as patterns form and break.
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Buy high and sell higher means the market needs to have a bullish outlook. Momentum traders don’t typically fare as well in bearish markets. While it is possible to make a living shorting as a momentum trader, it comes with much more risk and volatility. The better course of action is to identify good news and positive sentiment around a stock, then ride this momentum to the peak. Take profits before the stock hits resistance, rinse and repeat.