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The Advantages and Pitfalls of Momentum Trading

Jason BondJason Bond ·

Momentum trading may appear to many as less of a strategy for investing and more like an emotional reaction to information about a market. The thought of selling stocks that aren’t doing well and buying thriving ones makes sense to the average investor. However, it is the exact opposite of the famous Wall Street adage of "buy low and sell high." For this reason, investors need to understand what momentum investing is along with the benefits and shortfalls associated with it.

What Is Momentum Trading Strategy?

Momentum trading is a strategy in which investors buy and sell stocks according to recent strengths of price trends. In physics, momentum is found by multiplying the mass of an object by its velocity to help determine how likely it is to continue on a particular path. In financial markets, other factors help determine momentum, including the rate of price changes and trading volume. Investors bank on the assumption that stocks are actively moving in a given direction and will most likely continue moving in that direction until that trend loses strength.

The Start of Momentum Stock Trading

While Richard Driehaus was not the first momentum trader, he used the practice and developed it into a strategy he used to manage his funds. He believed investors could make more profit "buying high, selling higher" than purchasing stocks that were underpriced and having to wait and hope for the market to re-examine them. His philosophy was to sell the loser and let the winners ride, using the cash from the losers to purchase more stocks that were starting to gain momentum. These techniques used by Richard Driehaus became the cornerstone for what we now call momentum trading.

Parts of Momentum Trading

Momentum trading requires detailed risk management guidelines addressing unseen traps that reduce profits, volatility, and overcrowding. Investors can be tempted to bypass these rules, worried they’ll miss the rally or sell too early while everyone else is making huge profits. These basic guidelines can be divided into five main areas:

  1. Selection of what equities to choose.
  2. Risk revolves around trade opening and closing timing.
  3. Entry timing is in reference to entering into the trade early.
  4. Position management combines your holding period and wide spreads.
  5. Exit points requiring charting consistently.

Momentum Trading Security Selection

Experts recommend selecting liquid securities and staying away from inverse or leveraged ETFs when using a momentum stock trading strategy due to the latter’s price swings not accurately tracking futures markets or underlying indices because of complicated fund construction. Traditional funds are excellent vehicles to trade but tend to show smaller gain and loss percentages than individual securities.

Whenever possible, look for securities trading more than 5 million shares daily. Several known stocks meet this criterion. However, even low float issues can result in instruments becoming highly liquid when intense emotional reaction and news flow bring in other investors from various sources.

Watch for the "flavor of the day" when new concepts, products, or divisions catch the public’s attention. This often forces analysts to toss away any re-compute profit estimates and calculations. Small to mid-size tech companies and biotechs create a large number of these story stocks.

Managing Risk Control Tightly

For the momentum trading strategy to be successful, we need to address risks associated with the equation in detail. Potential pitfalls of momentum trading can include:

  • Entering into a position too early, before confirming a momentum move.
  • Being late to close the position after saturation is reached.
  • Not watching the screen, missing signs of news, changing trends, or reversals that can surprise the market.
  • Keeping positions open overnight as stocks are especially prone to external factors that happen after the close of the day’s trading, causing radically different patterns and prices the following day.
  • Not acting quickly enough to close a bad position.

Timing Entries Perfectly

The ideal momentum trades occur when news shocks happen, triggering rapid price movement from one level to another. This results in observant investors jumping in to buy and sell and getting rewarded with immediate profits. The next cluster of momentum capital enters as the stock evolves, creating contrary swings that weed out weaker hands. Finally, the hot money group hits an extreme resulting in major reversals and volatile whipsaws. Early positioning offers the most substantial reward with lower risk while avoiding aging trends at all costs.

Mastering Position Management

It can take a while to master position management as these stocks usually include wide bid/ask spreads. More significant movements in your favor are required with wide spreads to achieve profitability while navigating through various intraday ranges exposing stops while technicals remain intact.

It’s essential to select your hold period wisely as the more time you stay positioned, the risk increases. Momentum day trading works well but requires investors to take higher positions to make up for increased profit potential associated with multi-day holds. However, it’s best to decrease the size of your position when holding through several sessions, so increased movement and stop placement occurs further away from the current action.

Exiting Profitably

When the price is rapidly moving into a weakened technical state, shown via a series of vertical bars on a 60-minute chart, it’s time to exit. Alternately, the price can enter the third or fourth standard deviation of a bottom or top 20-day Bollinger Band. Consider a blind exit or tighten up stops when technical barriers are hit like previous high/low or a significant trendline. Take partial profits or exit when crossovers show potential trend changes.

Benefits of Momentum Trading

Momentum trading can result in significant profits for the investor with the right personality, someone who can deal with the associated risks while committing to the momentum trading strategy. Benefits can include:

  • High-Profit Potential in a Short Period of Time: If a stock you purchase grows from $25 to $37.50 due to an overly positive analyst report, you can sell that stock at a profit of 50% before the price corrects itself.
  • Taking Advantage of the Market’s Volatility: Momentum trading is all about capitalizing on the volatility of market trends, looking for stocks that are on their way up to buy and selling them before the prices start decreasing.
  • Taking Advantage of Other Investor’s Emotional Decisions: As opposed to being controlled by an emotional response like many traders, capitalize on the changing prices resulting from emotional traders.

Drawbacks of Momentum Trading

Momentum trading also includes a few downsides with the same risk-return tradeoff found with other investing strategies playing a hand in momentum trading. Making a buy at the wrong time resulting in being underwater is a risk that momentum investors have to accept in return for hopes of higher returns. Other drawbacks associated with momentum trading include:

  • High Turnover: Fees associated with higher stock turnover can be expensive. While low-cost brokers are starting to put an end to the high fees problem, it continues to be a significant concern for momentum traders just starting.
  • Time-Intensive: Momentum trading requires traders to monitor the details of the market daily, sometimes even hourly. Since the stocks they are dealing with will crest and decrease momentum again, investors need to be able to get in and out early. This requires them to watch all updates, seeing if any negative news updates may spook other investors.
  • Market Sensitivity: Momentum trading is best in a bull market as traders are likely to herd more than in a bear market where the profit margin on momentum trading decreases along with increased caution among investors.

Will It Work for You?

While momentum trading has been proven to work, it may not be a practical strategy for all traders. Utilizing momentum trading strategies as an individual investor will likely result in overall losses to your portfolio. When individual investors are buying a rising stock or selling a falling one, they are probably reacting to old news rather than other professionals leading momentum investing funds.

While the larger professional investors get out in time, they may leave you and other singular investors with significant losses. If smaller investors can manage the timing just right, they still have to be more aware of turnover fees, assessing how much of their returns they will eat up.

The Bottom Line

Utilizing momentum trading strategies isn’t for everyone; however, if done correctly, it can result in impressive returns. Momentum trading takes intense discipline as trading with this type of strategy requires closing at the first sign of weakness, with funds being immediately used for the purchase of a new stock showing strength.

While factors like commissions have made momentum trading impractical for many individuals or new investors, we are seeing a slow change in this as low-cost brokers enter, taking on a more influential role in short-term active traders’ careers.

Learn more about momentum trading and other option strategies in Jeff Bishop’s eBook "Option Profit Accelerator."

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