What is momentum trading?

Momentum trading is an investing strategy in which one makes trades based on the apparent trend of asset prices. One will sell an asset if the price is falling but will buy an asset in a positive trajectory. This investing strategy pre-dates value investing. David Ricardo, a famous 18th Century economist, is popular for letting profits run on while cutting losses. In short, he sold losing stocks and bought winning stocks!

Looking at it carefully, the concept of momentum trading is similar to the concept of momentum in physics. A fundamental law of physics says that a body is likely to stay in motion if the product of its mass and velocity is sufficient. In like manner, an asset’s price is expected to keep up the course if price action and trading volume are adequate.

Momentum in Stock

Figure 1: Momentum in Stock

From the foregoing, momentum trading does not consider the fundamentals of an asset. Instead, it relies entirely on technical analysis. The wisdom behind this trading strategy is that traders tend to respond positively to new information about the prices of assets. If the recent stock price is falling, for example, investors are most likely to sell the stock to cut losses.

How to find momentum stocks

In the most basic sense, momentum traders are trend followers. To be sure, different traders use different tricks to find momentum stocks. Unfortunately, some use random guesswork, which increases the chances of faulty momentum trading strategies. The best way is to create criteria based on which you select momentum stocks.

An excellent example of such criteria is as follows. Use earnings growth. Bull trending momentum stocks have one defining quality; their revenue and EPS show consistent growth. How do you then use this criterion? Many stock screeners on the web, find stocks whose EPS and revenues have registered new highs quarter-over-quarter for the past 12 months. Alternatively, one could pick out stocks whose year-over-year EPS growth is consistently higher. 

Often, selecting momentum stocks results in more accurate choices if one combines criteria. In addition to earnings growth, one could focus on returns. In this case, one needs to consider another critical quality of momentum stocks, which is that they often outperform the market. To this end, search the web for stocks whose returns over the past quarter/half-year/year have outperformed the market. 

To refine your selection, consider this third criterion where you select stocks that have set new 52-week highs. Stocks that set new 52-week highs consistently year-over-year tend to be bullish for a long time. On Barchart, one can find a comprehensive list of all US stocks with 52-week new highs. The website lists stocks from all exchanges. Preferably, one should arrange the shares in order of the number of times their price has reached a 52-week new high.

Altogether, these criteria offer an effective method of finding high momentum stocks. The idea is to find the stocks with the highest probability of moving ever closer to new highs or new lows. 

How to trade intraday momentum

Momentum investing is more profitable in a volatile market. Volatility implies that price action is fast-changing, and the trading volume is massive. With such conditions, traders can take short-lived positions in the market and make substantial returns. For this reason, momentum trading is popular in day trading/intraday trading.

Day traders move fast, and they lack time to dissect a company’s financial information. They need to enter the market in a trading session and exit before the session closing. At the end of it all, they need something good in their accounts.

Scalping is the most common day trading strategy for momentum traders. Intraday, many news reports concerning particular stocks are coming out. For instance, a company might release its earnings report, which causes a huge jump in trading volume. The resulting volatility leads to immense volatility of the price.

For the sake of emphasis, let us remind readers that intraday trading is short-lived. In this sense, traders should be ready to exit their positions the moment signs of trend reversal show. Additionally, gain more when they lead the pack. 

Consider the Apple intraday chart below for June 19, 2020. The general trend of the market is upward facing. However, there are few instances during the day where the trend reversed. For a momentum intraday investor who suspected a trend reversal, entering a position at Point A and exiting at Point B would have earned about $2. 

Apple Stock for June 19, 2020

Figure 2: Apple Stock for June 19, 2020

Nevertheless, this is only possible if the investors had been ready to exit after the small green candlestick at Point B. Remember, the trick in intraday momentum trading is to lead the herd. A few things emerge here. First, you need to have a sharp instinct and quick reflexes. Second, you must never second-guess yourself.

Pros and Cons of momentum trading

As it is apparent, momentum investing does not come without risks. Depending on how an investor handles the strategy, one might encounter more positives than negative. Nonetheless, here are some advantages and disadvantages of momentum stock trading.

Pros

In momentum investing, traders can make tens of trades in a single day. With each trade earning a small profit, the return is substantial when summed up at the end of the day. Therefore, one does not have to hold onto a position for painstaking periods waiting for the stock to break even. 

Additionally, herd mentality is a significant force in the stock market. When a stock is gaining, everyone wants a piece of the potential returns. Similarly, investors want to cash in when a stock is bearish. In this sense, momentum investing is a commonsense strategy that almost anyone can exploit.

Cons

The downside of momentum investing is that it defies the essential wisdom of stock trading. Primarily, experts advise that buying low and selling high is the best strategy because stock prices increase in the long term. Therefore, going the momentum investing way presents more risks in an already risky environment.

Secondly, momentum investing, especially intraday, is high speed. Investors need fast fingers and quick and accurate instincts if they are to earn anything with this strategy. In a sense, investors who use this strategy multiply the risk of losing their money. It is especially true if something beyond their control goes awry, say poor internet connection.

Bottom line

All stocks show a tendency to stay a particular course during trading sessions. Usually, the volatility of price action and the volume traded greatly influence the momentum in the price movement. This strategy is ideal for fast traders, such as scalpers, because it is entirely technical. Investors do not have the time to analyze a company’s fundamentals.

Momentum trading is a commonsense strategy because of investors’ herd mentality. A stock that is gaining is likely to continue gaining until it reaches a saturation point before reversing the trend. Nonetheless, this strategy remains high-risk unless you have an eagle’s eye that keeps you ahead of the herd.