Momentum trading is a trading strategy that aims to capture the existing momentum of stocks in your portfolio to earn a profit. Momentum traders buy and sell stocks and other assets based on technical analysis, patterns and trading volumes to predict future stock price movements. While momentum investing may be an exciting way to enter the markets, many detractors note that momentum trading does not guarantee profits.
The Short Version
- Momentum investing is a strategy of actively buying and selling stocks based on technical analysis.
- This strategy assumes that a stock going up will follow the same momentum.
- It's considered a risky investing strategy because you are actively trading on news and trends and could see more volatility in your portfolio as a result.
- There are specific strategies that momentum investors use, including price-based signals and longer-term moving averages.
What Is Momentum Investing?
Momentum investing — more appropriately called momentum trading — is a stock market strategy of actively buying and selling stocks based on technical analysis. The basic premise of momentum investing is that stocks on the way up will likely keep going up, and stocks going down will likely keep going down, assuming market conditions don’t change.
Momentum traders look at charts showing past price history alongside trading volumes and other indicators to predict the short-term future of a stock price. If they guess (and trade) correctly, traders can profit from the stock’s momentum. However, it doesn’t always work out as planned.
How Does Momentum Trading Work?
Momentum trading strategies assume that a stock going up with strong demand will follow the same momentum. Momentum traders use a combination of active trading tools and news sources to identify potential trading opportunities.
The big problem with momentum trading happens when the past doesn’t accurately predict the future, which happens regularly in financial markets. If you buy a stock on the way up and sell on the way down, there’s a good chance you’ll miss on the goal to buy low and sell high. When you’re always chasing the markets, detractors say, you’re unlikely to walk away with big profits.
Relevant Technical Analysis Tools for Momentum Trading
Momentum traders typically rely on an active trading platform designed for users focused on technical analysis. This includes active trading tools, advanced charting features and the opportunity to enter complex trades, among other requirements.
These are the most important tools for momentum investing:
- Active trading platform: Virtually all momentum traders rely on an active trading platform. Popular brokerage firms for active traders include TD Ameritrade, Robinhood, Public, Interactive Brokers and TradeStation.
- Advanced charting tools: While you can learn a lot from looking at a basic chart, many brokers offer advanced charting features, as well as the option to add dozens of overlays and data points to help make the best, most timely investment decision.
- Advanced order types: Advanced orders will automatically execute a trade if specific conditions happen in the markets. This goes beyond limit and stop-loss orders. Advanced order types include once-cancels-other (OCO), bracket orders, stop-limit orders, trailing stops and other multi-condition orders.
- Trading APIs: The most advanced traders can set automated trading rules using application program interfaces (APIs). These are for traders with advanced computer skills.
What Are the Risk Factors of Momentum Investing?
Compared to long-term, passive investing based on fundamental analysis, momentum investing is generally considered quite risky. Because you’re actively trading based on current news and trends, you’re likely to see more volatility and a higher potential for losses than with more passive investment styles.
With fundamental analysis, investors buy and sell stocks based on the financial data from the underlying stock. That’s likely a less risky investment strategy than one based on technical analysis of recent market trends.
A news story, financial report or economic indicator can quickly ruin a momentum trading strategy. That’s not the case with long-term investing based on a company’s fundamentals.
How to Time Your Entry and Exit
Every trader develops their own preferences and strategies for exactly when to buy and sell. When getting started, look at the stock’s trendline over a period of time. These are some of the most common technical indicators used by momentum investors:
- Moving average: A moving average is a trendline that shows a stock’s trajectory over a specific period of time. You may want to measure trendlines over multiple overlapping periods to understand the stock’s momentum over different timespans.
- Overlays: Overlays are lines and markers placed on top of the stock’s chart. Bollinger Bands, for example, look at an upper and lower limit based on a standard deviation of the stock’s 20-day moving average.
- Oscillators: Indicators such as the moving average convergence divergence (MACD) help investors understand the stock’s price and trading momentum, among other vital information for certain trading strategies.
Momentum Investing Strategies
There are several popular momentum investing strategies to get you started:
Longer-Term Moving Averages (MAs)
Don’t limit yourself to a 10-day or 20-day moving average. Instead, review longer-term moving averages, like the 200-day or 100-day moving average when making trade decisions.
Using chart patterns and technical indicators, investors look for price-based buy and sell signals. For example, the golden cross and death cross are popular buy and sell signals when the 50-day and 200-day moving average intersect on a chart, and signal a future upward or downward price movement.
Savvy traders may overlay and compare two different stocks, benchmarks, or indices. If several stocks in a sector rise, for example, one may believe related stocks will soon follow with the same momentum.
CAN SLIM is an acronym for an investment strategy that combines fundamental analysis and technical analysis to make investment decisions.
Benefits and Risks of Momentum Investing
Momentum investing is an exciting way to invest. When you hit it right, you could walk away with significant short-term gains. While short-term investments are taxed at a higher rate, a profit is a profit, and it’s definitely better to make money and pay taxes than not make money at all.
While you may find a winning strategy, momentum investing is a form of active investing considered riskier than passive, long-term investing. If you want to spend less time on your investments or want less risk, consider value investing as an alternative.
Is Momentum Investing Right for You?
Momentum investing isn’t right for everyone. Most investors are better off with a passive investing strategy focused on low fee index funds. However, those who want to take an active, hands-on approach may find momentum investing appealing.
If you decide to move forward with technical trading, remember to start slowly. Consider paper trading or a stock market simulator before investing real dollars. Once you understand momentum trading strategies well, you can wade into the waters and move forward with your first trades.