If you’ve done any research on making money in the stock market, you’ve heard a story or two about a momentum trader who made it big by banking on volatility and earning thousands of dollars a day. The allure of these stories leads many down the road of day trading, where momentum is one of the most common tools used.
Momentum traders take advantage of fast-paced movements in the market in an attempt to earn quick profits.
While this style of trading does take work and practice, it has very real potential to become a full-time job for the right trader. But what exactly is momentum trading, what are the risks, and should you consider diving in?
What Is Momentum Trading?
Movement in the financial markets tends to happen through patterns of peaks and valleys. While the average investor isn’t interested in these short-term price movements, it’s these fluctuations in stock prices that the trader lives for.
Momentum trading is similar to swing trading in the sense that both momentum traders and swing traders are looking to profit off of short-term price movements; but there’s one key difference. Swing traders enter and exit trades at support and resistance levels, while momentum traders would rather trade in the middle of the price trend.
The ideal momentum trader is patient and precise, allowing trends and trading volume to warm up before pouncing on an opportunity. Successful traders are also well aware of fear and greed and able to prevent emotional trades, exiting positions before it’s too late.
A momentum trader patiently waits for the right moment to strike. When a clear uptrend is in play, the stock is hot and the trader dives in. While the trade is active, the trader pays close attention to chart patterns for sell signals and attempts to sell before the stock price peaks and heads for a downtrend, or “turns cold” in trader lingo.
See the image below, noting a momentum trader’s entrance and exit points:
How Momentum Trading Works
Momentum traders rely heavily on technical analysis for buy and sell signals, paying close attention to trading volume. High trading volume and a fast-paced movement of the asset’s price in an upward direction suggests that upward momentum is high, signaling them to buy. From there, the trader relies on changes in technical indicators for sell signals.
Popular Technical Indicators for Momentum Trading
There are several momentum indicators traders use to gain an advantage in the market. Most trading platforms offer these and other indicators as options on their stock charts that you can view alongside your chosen stock’s price. Some of the most commonly used indicators include:
Moving Average Convergence Divergences (MACD)
The MACD is an oscillator, meaning it uses high and low extremes to create boundaries and offers a trend indicator between the two extremes to suggest overbought or oversold conditions.
The MACD uses moving averages to create the two boundaries, generally the 12-day and 26-day moving averages. From there, the 26-day average is subtracted from the 12-day average to create the trend line. This trend line is then graphed along with a 9-day moving average. When these two lines get closer, farther away, or cross one another, these actions act as momentum signals.
The most important part of the MACD is the histogram, which shows the difference between the 9-day moving average and the MACD trend line. When the histogram is below the midway point and begins to climb toward it, it signals a weakening downtrend, while a histogram above the midway point that’s falling back toward it signals a weakening uptrend.
The MACD is generally shown below the primary stock chart. See the image below for an example:
Relative Strength Index (RSI)
The relative strength index (RSI) is another oscillator, meaning it’s an indicator that fluctuates between two extremes. The RSI of a stock ranges between zero and 100. The indicator offers a measurement of stock price changes and the speed at which those changes take place.
When the RSI reading is 50 or above, it suggests that the trend is moving upward, with higher readings suggesting increased momentum. However, once the RSI reading gets to 70, it’s an indicator that the stock asset is overbought and will likely begin to fall in value relatively soon.
Conversely, when the RSI reading is below 50, it’s an indication of downward momentum. Once the reading reaches 30, the asset is considered oversold and is likely to make an upward reversal relatively soon.
Average Directional Index (ADX)
The Average Directional Index (ADX) is an indicator used to show the strength of a trend. When the ADX is over 25, it suggests that the trend is strong. The trend is considered weak when the ADX is below 20.
The ADX is displayed as a single number, but doesn’t show the direction of the trend. As a result, it’s generally coupled with a negative directional indicator (-DI) and positive directional indicator (+DI). The complete indicator often appears as three lines on the chart: the ADX line, the +DI line, and the -DI line.
Where the +DI and -DI lines cross over one another helps to create buy and sell signals. The +DI line crossing above the -DI line is a buy signal, and the -DI line crossing above the +DI line creates a signal to sell.
For example, when the +DI crosses above the -DI and the ADX is 20, it’s a weak buy signal. If the ADX is above 25 in this instance, the signal is a strong buy. On the other hand, if the -DI crosses above the +DI and the ADX is 20, you’re seeing a weak sell signal. If the ADX is above 25 in this case, it’s a strong sell signal.
Like the MACD, the ADX indicator is generally displayed below the stock chart. See the image below, where the black line is ADX, green is the +DI line, and red is the -DI line.
Momentum Trading Strategies
Most strategies used by momentum traders are day trading strategies designed to capitalize on short-term price movement. These strategies employ technical indicators to produce buy and sell signals. Two of the most common strategies used by traders include:
Buy Low, Sell High
The buy low, sell high strategy is one used by traders who attempt to buy at the lowest possible price in a defined trend and sell at the highest possible price, making the spread in the middle as profit. The strategy employs the use of technical analysis to tell the trader exactly where the low and high points lie.
When following this strategy, it’s important to follow it to the letter, avoiding emotion through the process. This is because the strategy attempts to get you as close to a reversal as possible before a sell signal is produced. As a result, if you find yourself getting greedy in the trade and holding on for too long, you may hold the asset through the reversal, leading to losses rather than profits.
Scalping is a very short-term trading strategy that works by making several trades, with each trade producing a minimal profit. However, because there are several trades made through a trend, the small profits created with each trade add up to become meaningful.
When using the scalping trading strategy, the trader starts by finding and defining a high-momentum trend. Once the trend is defined, the trader enters positions, generally setting parameters on the trade through stop loss and limit orders. As soon as the trade works its way into profitable territory — no matter how small the profit might be — the trader closes the position, taking profits and preparing for the next scalping.
Pros and Cons of Momentum Trading
Making profits from fast-paced price action is an exciting process, and those profits have the potential to be incredible. However, you won’t be successful with every trade, and there are drawbacks to consider before getting started.
Pros of Momentum Trading
There are several benefits to trading assets that experience high-momentum trends. Some of the most significant benefits include:
- Potential Profits. While becoming an expert trader takes plenty of work and experience, it’s an incredibly lucrative action for those who are successful. Some traders make six figure incomes in the market on a regular and reliable basis.
- Excitement. Let’s face it, investing and finance isn’t always the most exciting topic. However, for many, the fast-paced action involved in momentum trading creates quite a bit of excitement, making earning money in the market fun.
- Freedom. Due to the high profit potential, those that learn to be successful traders are often able to quit their jobs and enjoy a financially free life, rather than being strapped to a nine-to-five job.
Cons of Momentum Trading
Sure, trading high-momentum assets is exciting and has the potential to generate significant profits, but there are some downsides to doing so as well. Some of the biggest risks to consider include:
- Volatility. Trading high momentum assets is nothing more than exploiting volatility in stock prices for profits. While that sounds great, the fact is that highly volatile stocks also tend to be highly unpredictable, introducing a high level of risk to the process.
- Short-Term Trading Risk. The vast majority of momentum strategies are centered around short-term trades. When making predictions, which is essentially what you’re doing when you trade, the shorter the time frame, the more inaccurate those predictions are likely to be.
- Emotion. Short-term fast-paced trading strategies are exciting, but that excitement also breeds emotion. Emotions like fear and greed have the ability to make you want to prematurely open or exit positions, or even hold onto positions longer than you should, all of which can lead to losses. If you’re going to take part in this style of trading, it’s important that you check your emotions at the door.
Should You Practice Momentum Trading?
Momentum trading strategies generally take place over a very short period of time and come with high levels of risk, so they’re not for everyone.
So, who’s the perfect candidate to become a momentum trader?
- A Healthy Appetite for Risk. If anything’s been hammered home here, it should be that while momentum trading is exciting, it’s risky. Therefore, the prime candidate for this process is a relatively young investor (not anywhere near retirement) with a healthy appetite for risk.
- Interested In Charting. Traders must rely on technical analysis to determine when to buy and sell assets. This requires quite a bit of charting. As such, the best candidates for momentum trading have an interest in becoming deeply familiar with charts and technical indicators.
- Self Control. Finally, this type of trading has the potential to induce emotions that can lead to significant losses. The perfect candidate doesn’t just use technical analysis to know when to hold ‘em and when to fold ‘em; they also have the self control required to trust and act on their analysis.
Always Practice Risk Management
If you decide that momentum trading is something you’d like to get into, great. But it’s important to protect yourself. When trading, always use a risk management strategy that utilizes a stop-loss order. These order types will automatically close your trade at a predetermined loss limit that you set to ensure that no single trade results in losses you can’t afford to sustain.
Learn Using Trading Simulators
Finally, before trading with your hard-earned money, you’ll want to practice using virtual money. That way, if you lose while you learn, you have the opportunity to tweak your strategy before taking on any real losses.
There are several trading simulators available online. These simulators display real-time market data, giving you the ability to place fake trades in an environment that feels like the real deal. If your strategy fails in the simulator, it will fail in real life. Conversely, strategies that do well in the simulator are likely to do well when real money is on the line.
With that in mind, keep using the simulator until you dial in a strategy that has a high percentage of winning trades. At this point, you’ll be ready to use real money to make your trades, and the added confidence from the practice you did with the simulator will only help your cause.
Consider Momentum Investing
Short-term trading is a high-risk process that should only be used by those with experience and a healthy appetite for risk. If that’s not you, consider momentum investing as an alternate way to use momentum in the stock market to your advantage while sticking with a longer-term strategy.
Momentum investing focuses on buying stocks that have performed well consistently over a longer period, usually several months. Momentum investors look for trends that are clear and have sustained for an extended period of time. Once these trends are found, the investor takes a long-term position in the asset, looking to capitalize on its upward momentum.
You can use many of the same indicators for momentum investing as with momentum trading, except zoomed out to look over longer time periods to look for longer-term trends. Also, because momentum investing involves potentially holding onto your purchases over the long term, you’ll want to place additional emphasis on doing a proper fundamental analysis on the assets you consider for this strategy.
Momentum trading is an exciting way to make money in the stock market. However, it also comes with significant inherent risks. As such, only those with a high risk tolerance and plenty of time for their portfolios to bounce back from any losses should consider taking part in the process.
If that’s you, take the time to do your research and use a simulator to pin down a strategy before getting started for the best chances of success.