Momentum Trading: A Comprehensive Guide for Beginners

Momentum Trading: A Comprehensive Guide for Beginners

At first, momentum trading looks like it isn’t really a trading strategy. For some, it’s merely what it is—riding on top of the trend. Let’s dissect momentum trading and see its benefits and drawbacks.

A Brief Throwback

Once upon a time, Richard Driehaus learned how momentum trading works and chose it to be his strategy. He wasn’t the first momentum investor, but his philosophy made the practice better.

In a nutshell, his philosophy is to simply “buy high and sell higher.” That goes against the buy low and sell high dichotomy. The latter adage tells us that we should initially buy underpriced stocks. Then we wait until the market comes to its senses and re-evaluate the price.

Driehaus didn’t really oppose that, but he believed that selling losers while winners ride is better. He did so while reinvesting the money he got from losing stocks to “the next big thing.” A big part of the basics he used became a part of what we now call momentum trading.

momentum trading infographic

The Idea behind Momentum Trading

Basically, momentum trading takes advantage of market volatility by going short in rising stocks, and selling them once they present signs of falling. The last move is to move the earnings to a new position.

A metaphor: volatility is an ocean wave that you ride. You jump off ship before the next wave comes.

If you’re a momentum investor, you take advantage of investor herding. You lead the pack in, and you’re the first to take the money and exit.

Read further: How Can Stock Market Volatility Affect You Today

What Should You do to be a Momentum Investor?

If you think momentum trading would suit you well, you got to have efficient risk management. This is because you are practically going toe-to-toe with market volatility. You also risk overcrowding and hidden traps, all of which reduce your potential profit.

See also: Several Types of Investment Risks

Many market participants don’t seem to be aware of these rules. That’s because they can’t see through the enormous fear of missing the rally. It’s equally possible they’re afraid of selling off while everybody books windfall profits.

The following are the things you should consider if you want to try momentum trading:

Security Picking

Avoid leveraged ETFs or inversed ETFs, whose price swings do not accurately trace underlying indexes or futures markets. That’s because of their complicated structure. Additionally, regular funds tend to eat away smaller percentage gains and losses.

The fix: liquid securities.

Chase after securities that can trade over 5 million shares a day. Your choices: popular stocks. You can also hunt among low float issues, which can turn into highly liquid instruments. How do they become highly liquid? When news flow and intense emotional responses attract market players.

Keep an eye on the next hot thing in the market, like a new product that amuses the market’s attention. This compels analysts to ditch calculations and re-assess profit estimates.

Learn more about ETFs and Mutual Funds. Read ETFs vs Mutual Funds

Risk Control

The same with any other trading strategy, you must address and acknowledge all the potential risks you might face. You must avoid the following:

  • Entering a position too soon (when you haven’t confirmed a momentum move).
  • Exiting the position too late (when it’s already oversaturated).
  • Not keeping close tabs on the movements.
  • Missing trend changes, like reversals.
  • Ignoring important news that affects the market.
  • Keeping a position open throughout the night. Stocks are subject to outside factors that exist after the trading day. Such factors cause drastically different prices and patterns. You’ll probably faint when you wake up and see them.
  • Not closing a bad position right away (it’s like taking a ride to the wrong direction)

Learn more about what to consider. Read Factors to Consider in Your Investment Plan

Entry

Looking for the best momentum trades can be tricky. But all you have to remember is that the best momentum trade comes after a shock. News that takes the market by surprise can be a good example.

Such news triggers quick price movements, which sets off buying and selling signals. You have to be observant if you want to get instant profits. You momentum capital shall come as the trade evolves. That will, in turn, generate swings that shake weak trades.

To get the greatest reward with the least risk, choose early positions. Meanwhile, avoid aging trends as much as you can. In the real world, the opposite happens. This is because one can see the opportunity only after-the-fact. That persons ends up missing the party, not acting until all have jumped in.

Position Management

You cannot learn position management overnight. They carry wide bid/ask spreads. They require bigger movement to reach profitability. If you can do the latter, they will also grind through wide intraday ranges, which expose stops. That’s also true even if technicals are unmoved.

You have to choose your holding periods cleverly. The risk increases as you stay longer in the position. Day trading complements momentum strategies, though it compels players to take larger positions. Taking larger positions offset multiday holds’ greater profit potential.

Now, it’s best to diminish the position size if you’re holding through multiple sessions. That way, you can have some wiggle room for greater movement. You can also stop the placement further away from the present movement.

See also: What is position trading? 

Exits

When to exit? Leave when you notice that the price is moving quickly into an overextended technical state. You can identify such states via a series of vertical bars on a 60-minute chart. Lastly, you can also determine this state through price breaking third or fourth standard deviation of a  top or bottom 20-day Bollinger band.

You must tighten up stops (or blind exit) if your trade hit technical barriers. Some samples of these barriers are major trendlines or prior high/low. Once you see crossovers hint at trend changes, it’s time to exit or take partial profits.

Momentum Trading
Momentum Trading is quite tricky, but we’ll help you understand it.

Advantages of Momentum Trading

Here are the possible benefits you can get if you do momentum trading:

High Profits, Short Time

We won’t be discussing this if you can’t earn big through momentum trading. For instance, you buy a stock that grows from $25 to $50 based upon an extremely bullish report. Afterwards, you sell at a profit of 50 percent prior to correction of the stock.

You’ve just made a 50 percent return in just a few weeks. As time goes by, you profit potential can grow using momentum investing. And they can be incredibly large.

Leveraging Volatility in Your Favor

What really matters when momentum investing is to capitalize on volatile market trends.

If you’re a momentum investor, you look for stocks on their way up. Then, you sell them before their prices start to slide back or drop lower. If you want to maximize your ROI, you got to be head of other investors.

Take advantage of Emotional Investors

It’s not as nasty as it sound.

The idea behind momentum investing relies on going after performance, according to Ben Carlson. On the other hand, you, as a momentum investor, must do it in a systematic way. Your emotions or emotional responses shouldn’t control you.

Instead, since emotional investors cause stock prices to move, you have to find a way to benefit from those movements.

Disadvantages of Momentum Trading

Like any other trading tactics, momentum trading also carries some drawbacks you should be wary about.

Risk/Return Tradeoff

You’re always at risk of not timing the buy correctly. You risk ending up drowning in losses. For most momentum traders, this risk is worth the rewards they could get.

High Turnover

You’ll have to allot some funds because high stock turnover can be expensive. This is a valid concern for beginner momentum traders. That’s true even if low-cost brokers pop up more and more nowadays.

Time Consuming

If you really want to be a momentum trader, you have to monitor the markets every day. It could be worse: you sometimes have to monitor it hourly. You are dealing with stocks that go up and then down again. You need to jump in quick, and get out as fast.

This entails long hours of watching updates to see any freaky negative news.

Sensitivity

When you are a momentum trader, you’ll find the bull market your best friend. This is because investors herd more. During a bear market, the margin for profit become smaller based on increased investor caution.

Should You Try It?

Momentum trading is legitimate trading strategy, which means it can work. However, it’s not for everyone. You can practice it, but it will probably lead to losses in your portfolio.

If you buy a rising stock or sell a falling one, you will react to older news. The professionals will be at the head, and they will leave out holding the bag. Even if you time it right, you still have to be careful of the fees. Such fees can eat away your returns.

Conclusion

If you’re willing to take those risks listed above, momentum trading can be good for you. In fact, it can lead to lucrative returns—if done properly. It takes serious practice, tons of times, and strict discipline to perfect this strategy.

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