Momentum traders are looking to take advantage of price action when a stock is trading higher or lower. If this is more your personality, then you’re going to need to learn how to trade momentum stocks. Generally, momentum traders buy and sell stocks within the same day, but some may hold on to positions for longer. When you’re first starting out, it’s hard to figure out what to look at for momentum plays. Before you even start looking at chart patterns or catalysts, you’re going to need to learn some basics.
How to Trade Momentum Stocks – The Basics
When you’re entering a momentum trade, you should be able to list the reasons behind your thesis and outline why the stock could continue to rise or fall. You should be able to do this concisely and easily. For example, you might believe a stock could build momentum — rather than revert to the mean — if there was a positive news catalyst, such as announcement of a strategic partnership.
Trends in the stock
When looking for momentum plays, examine the overall trend in the stock. If it is trending higher, you wouldn’t want to get short, as that would be a mean-reversion trade rather than a momentum play. Basically, the trend is your friend. If the stock is in an uptrend, consider buying it. Conversely, if the stock is in a clear downtrend and has been showing signs of weakness, you might consider shorting it.
Look at what the market is doing
When you’re trading off of momentum, always look at the overall market. This gives you an idea of whether the general tide is running with or against you. Certain exchange-traded funds (ETFs), such as SPY, QQQ, IWM, and DIA offer an indication of the bullish or bearish activity in the market. Momentum traders, generally, want to go with the flow.
Gauge the strength in the sector and industry
You also want to take into account industry or sector news, as well as the outlook for the sector. For example, after the infamous WannaCry cyber-security attack, cyber-security stocks were on fire and built momentum. Check out the 15-minute chart on FireEye Inc. (FEYE), a cyber-security stock, following the malware attacks.
At the time, for the entire business was favorable following these attacks — with more consumers and companies potentially demanding cyber-security products and services — most stocks in the industry were rising. Basically, if you’re learning how to trade momentum stocks, you need to stay up to date on news.
We briefly discussed catalysts earlier. Momentum traders are focused issues that can make significant moves and, generally, that requires the presence of a catalyst. As momentum traders, you are looking to trade in the direction that the market will react to the news, so long on a positive earnings surprise, for example, and short on a negative one. Catalysts include industry developments, earnings, company news or corporate actions and more.
For example, Blue Orca Capital noted it was initiating a short position in GDS Holdings Ltd (GDS), causing the stock to plummet.
If you were to short this stock when this news was announced, you would’ve gotten paid if you held it for the entire move. This is a classic momentum short with a catalyst. Understanding how catalysts affect a stock is one key to learning how to trade momentum stocks.
When you’re trading off of momentum plays, you should define your risk-reward potential before entering the stock. This gives you an idea of where you should take profits and cut losses. After you’ve done your analysis, come up with a risk-reward ratio and use it to determine where you would get out of the trade. In general, you should trade stocks with a risk-reward greater than 1-to-2.
Many momentum traders use technical patterns as an indication of whether momentum is likely to continue. Momentum traders care about price action, and you should have a clear grasp of some technical indicators to gauge momentum. Let’s look at one simple indicator you can use, the simple moving average.
The stock gapped up after a strong earnings report. Thereafter, it consolidated. However, the overall trend was still up. Once the 13-hourly simple moving average (SMA) crossed above the 30-hourly SMA, it was an indication the stock could trend higher. This is what we call the money pattern, and I actually took part in this move, but with call options.
If you want to learn how to trade momentum stocks, you might want to consider options on that stock. Options provide leverage and you could potentially multiply your money if you spot the trend and ride the wave.
Trading volume also gives you an idea of whether a stock is poised to build momentum. Heavier trading activity means greater liquidity, allowing you to get in and out easily. For example, Facebook Inc (FB) trades over 20M shares a day on average. Therefore, it is easily traded based on its momentum. On the other hand, if you see a stock trades less than 750K shares on average per day, it’s going to be difficult to get in. Moreover, the spreads could be wide.
Volatility is your friend
Momentum traders need volatility. In a low-volatility environment, momentum traders will tell you it’s difficult and hard to profit off of any moves, since most stocks become range-bound. With that in mind, look for the catalyst that can help move a stock out of its range.
Be mindful of your holding period
Momentum trading is primarily focused on profiting off of short-term price movements. Keep in mind that if you do not have the time allocated to be at your screen all day, you might have trouble doing it. Momentum traders focus only on what’s going to happen intra-day, and simply do not care how the stock might perform a year down the road (although there are some momentum traders that hold onto positions for more than one day).
These are just basics that you should take into account when you’re learning how to trade momentum stocks. They’ll help you get a jump start on becoming successful momentum trader, but it’ll take hard work and dedication to reach that ultimate goal.
Jeff Bishop is lead trader at WeeklyMoneyMultiplier.com and widely recognized as the Mensa Trader. He runs short-term trading strategies, using stocks, options and leveraged ETFs.