Introduction to Momentum Trading

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Introduction to Momentum Trading

On paper, momentum investing seems to be more of a response to market information than an investment technique. The concept of selling losers and purchasing winners is appealing, but it contradicts the tried and true Wall Street maxim of “buy cheap, sell high.”

In this post, we’ll look into momentum investing and its advantages and disadvantages.

Key Takeaways

  • Momentum investing is a trading method in which investors purchase rising assets and sell them when they seem to have peaked.
  • The idea is to work with volatility by looking for purchasing opportunities in short-term uptrends and selling when the stocks begin to lose momentum.
  • The investor then takes the cash and seeks for the next short-term rally or purchasing opportunity, and the process is repeated.
  • Skilled traders know when to start a position, when to hold it, and when to quit it; they can also respond to short-term, news-driven spikes or selloffs.
  • Risks of momentum trading include moving into a position too early, closing out too late, and getting distracted and missing key trends and technical deviations.

The Father of Momentum Investing

Though not the first to employ momentum investing, Richard Driehaus turned it into a method for managing his funds. His belief was that “buying high and selling high” earned more money than purchasing underpriced equities and waited for the market to re-evaluate them.

Driehaus believed in selling losers and letting winners ride, while reinvesting the profits from losers in other equities that were starting to rise. Many of the tactics he used established the foundations of what is now known as momentum investing.

Precepts of Momentum Investing

Momentum investing aims to profit from market volatility by taking short-term positions in equities that are rising and selling them as soon as they begin to fall. The funds is subsequently transferred to new positions by the investor. In this example, market volatility is analogous to ocean waves, and a momentum investor is sailing up the crest of one before jumping to the next before the first wave falls down again.

A momentum investor attempts to profit on investor herding by leading the pack in and being the first to grab the money and run.

Elements of Momentum Investing

To overcome volatility, overcrowding, and hidden traps that limit returns, trading momentum markets need complex risk management procedures. Market participants often disregard these guidelines, overwhelmed by the tremendous dread of missing the rise or selling out while everyone else reaps huge gains. The regulations are divided into five parts:

  1. Selection, or what equities you choose
  2. Risks revolve around the timing in opening and closing the trades
  3. Entry time entails entering the transaction as soon as possible.
  4. Position management combines large spreads and the length of your holding term.
  5. Exit points need regular tracking.
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Select individual stocks rather than mutual funds or ETFs to enhance the probability of selecting a liquid and volatile investment, and ensure that they have an average trading volume of at least 5 million shares each day.

Momentum Security Selection

When using momentum tactics, use liquid securities. Because of sophisticated fund architecture, leveraged or inverse ETFs’ price movements do not properly reflect underlying indexes or futures markets. Regular funds are wonderful trading vehicles, but they have lower percentage profits and losses when compared to individual stocks.

When feasible, look for equities that trade more than 5 million shares every day. Many popular equities satisfy these characteristics, but even low-float issues may become extremely liquid when news flow and significant emotional responses bring in market participants from many sources.

Keep an eye out for the “flavor of the day,” which occurs when new products, divisions, or ideas catch the public’s interest, compelling analysts to discard projections and recalculate profit forecasts. These tale stocks are abundant among biotechs and small to midsize technology businesses.

Momentum trading differs significantly from the traditional investing technique of purchasing cheap and waiting for a stock to climb.

Tight Risk Control

The risk side of the equation must be thoroughly handled or else the momentum approach will fail. The following are some of the dangers of momentum trading:

  • Taking a stance too quickly, before a momentum move has been proven.
  • After saturation has been achieved, closing the position too late.
  • Failure to keep one’s eyes on the screen, resulting in the loss of altering trends, reversals, or indicators of news that catch the market off guard.
  • Keeping an open position overnight. External influences that arise after the closure of that day’s trade are especially vulnerable to causing substantially different prices and patterns the next day.
  • Failure to respond swiftly to close an unfavorable position, causing the momentum train to go in the wrong direction.

Perfect Entry Timing

The finest momentum trades occur when a news shock occurs, causing fast movement from one price level to the next. As a result, alert players get buying or selling signals and are rewarded with rapid winnings. As the transaction progresses, more momentum capital enters, causing counter swings that shake away weak hands. The hot money population has now reached an extreme, resulting in unpredictable whipsaws and huge reversals.

Early positions provide the most payoff with the least risk, but aging trends should be avoided at all costs. In real-world settings, the reverse occurs since most traders do not spot the opportunity until late in the cycle and then fail to act until everyone else does.

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Position Management

Because these assets sometimes have huge bid/ask spreads, mastering position management takes time. Vast spreads need more movement in your favor to achieve profitability, while also grinding through wide intraday ranges that expose stops—even if technicals are still intact.

Choose your holding time prudently since the longer you remain positioned, the greater the danger. Day trading complements momentum methods, but it pushes traders to build bigger holdings to compensate for the higher profit potential of multi-day holds. When holding across numerous sessions, however, it is recommended to lower position size to allow for more mobility and stop placement farther away from the present activity.

Profitable Exits

Exit when the price is swiftly approaching an overextended technical position. On the 60-minute chart, this overextended condition is often characterized by a sequence of vertical bars. Alternatively, the price might break over the third or fourth standard deviation of the top or bottom 20-day Bollinger Band.

Tighten stops or contemplate a blind exit when technical hurdles such as a significant trendline or prior high/low are crossed. When crosses signify prospective trend shifts, exitors take partial gains.

Benefits of Momentum Investing

Momentum trading may result in huge returns for a trader with the correct attitude, who can withstand the dangers involved, and who is committed to sticking to the approach.

Potential for High Profits Over a Short Period

Profits from momentum investing may be substantial. Assume you acquire a stock that rises from $50 to $75 as a result of an excessively optimistic analyst report. Then you sell at a 50% profit before the stock price corrects itself. You’ve earned a 50% profit in a matter of weeks or months (not an annualized return).The profit potential rise from momentum investing may be staggeringly huge over time.

Leveraging the Market’s Volatility to Your Advantage

The ability to capitalize on turbulent market developments is critical to momentum investing. Momentum investors hunt for companies that are on the rise and then sell them before the prices begin to fall. Being ahead of the pack is a strategy for such investors to optimize their return on investment (ROI).

Leveraging the Emotional Decisions of Other Investors

The whole concept of momentum investing, according to Ben Carlson of the blog A Wealth of Common Sense, is founded upon chasing performance. Momentum investors, on the other hand, do it in a methodical manner that involves a specified purchasing and selling point. Rather than being influenced by emotional reactions to stock prices, as many investors are, momentum investors attempt to profit from swings in stock prices generated by emotional investors.

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Drawbacks of Momentum Investing

However, there may be rain for every silver-lined cloud. Momentum investing has various drawbacks. Momentum investment is subject to the same risk-return tradeoff as other investing techniques.

A momentum investor, like a boat attempting to cruise on the crests of waves, is constantly at danger of mistiming a purchase and ending up underwater. Most momentum investors are willing to take this risk in exchange for the chance of bigger profits.

High Turnover

Stock turnover may be costly in terms of costs. Even if low-cost brokers are gradually eliminating the issue of excessive fees, it remains a big worry for most new momentum traders.

Time Intensive

Momentum investors must follow market data on a daily, if not hourly, basis. Because they are dealing with equities that may spike and then fall, they must enter early and exit quickly. This entails monitoring all updates to determine whether there is any unfavorable news that would frighten investors.

Market Sensitive

Momentum investing is most effective in a bull market since investors herd a lot more. In a bear market, the profit margin on momentum investing diminishes in response to rising investor caution.

Will It Workfor You?

Momentum investing may be effective, but it may not be suitable for all investors. As an individual investor, momentum investing will almost certainly result in total portfolio losses. When you buy or sell a rising stock, you will be responding to older news than the pros at the top of momentum investing funds.

They’ll leave you and the other unfortunates holding the bag. If you do manage to time it well, you will still need to be more aware of turnover costs and how much they will eat away your returns.

The Bottom Line

Momentum trading is not for everyone, but when done correctly, it may provide significant results. Trading in this manner requires extreme discipline since transactions must be terminated at the first indication of weakness and money must be instantly transferred to another trade that is demonstrating strength.

Many traders find this form of trading unfeasible due to factors like as fees, however this is steadily changing as low-cost brokers become more significant in the trading careers of short-term active traders. The ultimate objective of momentum traders is to buy high and sell high, but this ambition is not without its hurdles.

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