About Momentum Trading
Momentum trading is a short-term trading strategy that looks to profit from high-volume moves in a certain stock's price. These traders look for breakout points in a stock price and then follow them with their trades either on the up or down side, looking to accrue profits from mass movements in stock price. Most momentum traders close out of their positions by the end of the day, as they make extensive use of margin to finance their gains.
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Significance
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The first indicator that momentum traders look for is high volume. As they derive their profits from concerted mass price movements, market froth guides them to potential buys. After that, they look for a stock that is testing its resistance levels. If a stock is just making a lot of noise and thunder, signifying nothing, a momentum trader will look elsewhere. Once a stock breaks a resistance level--either up or down--it comes into play for a momentum opportunity.
Function
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Momentum trading seeks out technical indicators of a resistance break. Many stock trading software programs show these trend lines for you automatically. Momentum traders do not attempt to buy at bottoms and sell at the top--rather, they jump on a price trend after a stock has clearly breached a resistance point and then either sell or short the stock when they have locked in sufficient profits. The greater the volume of trades in the stock, the less likely that the price momentum will reverse.
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Considerations
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The chief challenge in momentum trading comes down to knowing when to cut losses. Momentum traders really seek to eke out small profits in percentage terms on a daily basis. If a trade starts to reverse, the short-time horizon of the strategy makes it so that it's more sensible to exit a position once it starts going negative in order to limit losses over the long term. Luckily, resistance breaks with high volume--so long as the momentum trader gets into the trade before the saturation point--are generally relatively safe trading plays in most markets.
Prevention/Solution
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Getting in and out of the trade before the saturation point arrives is a significant challenge. The saturation point is the point at which buy or sell orders start to outnumber those on the opposite side of the trade significantly. Naturally, this point can be difficult to predict, and it's somewhere between luck and art for a trader to consistently avoid being caught in a saturated price movement. Conservatism helps momentum traders to avoid this more often. It helps to have a ballpark acceptable gains and allowable losses target for every trade to prevent emotional reasoning from interfering with trading efficiency.
Potential
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Momentum trading is a strategy that requires an extraordinary amount of discipline. Successful traders can really only afford to pay attention to one or two stocks at once, as they need to be able to react to changes in the market with lightening rapidity. Many momentum traders need to use margin in order to make significant profits, which magnifies the risks and increases the importance of stop-loss orders and other protective trading methods. Momentum trading falls somewhere between technical analysis and trend following, as it relies on skill sets developed by both strategies.
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Resources
- Photo Credit Ahmed Rabea, Flickr
