Momentum Trading

When done properly, momentum trading can produce very significant returns in a relatively short period of time.

Momentum trading is identifying, and holding, a fast rising (or falling) stock for a period of time - be in days, weeks, or months. In momentum trading, you are looking for stocks that are trending. Momentum traders use technical analysis to identify stocks that show the characteristics of either an upward or downward trend (to short). Trends can be either short, medium, or long term. Generally, in momentum trading, investors don't enter a trade unless a stock has already started to trend, preferring instead to buy into established trends. However, care is taken not to enter a trend too late, otherwise you will make very little, and could even lose money.

Of course, a stock rarely moves uniformly up or down, even in a trend. It tends to make smaller upward and downward movements within the overall trend. But a stock can also suddenly go down, and the momentum of movement (up or down) can also fizzle out.

Trading in momentum shares is not a 'buy and hold' strategy. Momentum shares are not identified using fundamental analysis, which seeks to measure a stock's intrinsic value. Momentum investors look at a stock's price, and the volume traded, to see whether a trend is occurring, and its' direction. These large movements in the market are often driven by large institutional investors buying or selling off stocks. A momentum trader will buy into a trending stock either right at the start of the trend, or early in the life of the trend. They will exit the trade preferably before the trend reverses - they are not looking to ride out a reversal like a value investor might.

In momentum trading, entry and exit points are often determined beforehand, at least in some momentum systems that use momentum trading within the context of larger cycles (and which have a very high success rate). Momentum traders tend to use the moving average as an exit signal. Taking a short-term average of about 5 days, and a longer-term average of 20 days, when the short-term average crosses below the longer-term average, that is a signal to sell as it usually means the stock is dropping. Different momentum traders use different periods of time to measure the moving average, but that is one possible setup.

Momentum traders might look for potential momentum stocks in the Wall Street Journal's NYSE Biggest Percentage Gainers list, in popular trading chat rooms (for which stocks are generating a lot of buzz), trading alerts (because those stocks may have significant volume traded that day), as well as listening to the news to see which companies are releasing news.

When the market opens, those stocks are watched in relation to the market, to see if they are traded more quickly, with more volume, than the rest of the market. Technical analysis is used, particularly the momentum line, and watching the level 2 screen shows the level of interest in the stock. Of course, there is an easier way.

What Can Go Wrong With Momentum Trading?

Trading is not an exact science, and things can go wrong. Whether it's due to lack of experience, emotions driving your actions, lack of knowledge, lack of mastery, or poor advice, the types of things that can go wrong in the momentum trading system are:

* poor to average stock selection

* you stayed too long, or not long enough, in a trade

* you entered or exited the trade at the wrong time

* poor stop placement

* you had too many stocks and your capital was thus too diversified to see any significant net gains

The most successful momentum traders use a system, and stick to it. It helps eliminate the interference your emotions can generate when a stock is performing well (greed) or badly.

References:

1. istockanalyst.com/article/viewarticle/articleid/3661191

2. investopedia.com/articles/trading/02/090302.asp