An Introduction to momentum trading
Momentum trading is a popular strategy when trading stocks that aims to benefit from strong and often short-term price trends. This article covers the essentials of momentum trading including key notions, principle and indicators that can help you get started.
Let’s start with a definition: Momentum is defined as the rate of acceleration of security’s price — or the speed at which the price is changing. Momentum trading is an investment strategy that aims to profit and capitalise on short term price movements and upward trends.
What is the objective?
Momentum traders are looking for performance, they invest in stocks that trend one way or another. A trending stock is deemed “hot” while a stock trending down is deemed “cold”. Their objective is to react to market information and enter a trend as soon as it emerges and exit when it loses steam or when the stock price appears to have reached its peak. Once a momentum trader sees acceleration in a stock’s price, he will often take a long position in the stock in the hope that its momentum will continue in an upward position. Traders then sell when momentum drops and repeat the process on the next uptrend. Once the trader believes the stock price has reached its peak, he would exit the trade and take profit or, in some case, open a short position to try to benefit from a short-term downward trend.Momentum traders aim to benefit from the “herding behaviour” of market psychology that translates in “buy high, sell higher”.
Momentum stocks typically carry larger price swings with high volumes that can generate big profits but also change quickly. The high risk/reward nature of this strategy requires traders to act in a non-emotional manner with appropriate orders in place such as take profits and stop-loss when entering a new position. While some stocks are momentum-driven by nature (due to good fundamentals), momentum often flows into small-caps or low-float stocks for a single day or two. News catalysts and special events (eg. patent approval for a healthcare firm) can turn these stocks into momentum stocks that rise double or triple digit percentages in a single day with volume spiking 5–10x higher than usual.
The importance of Float
Momentum traders are especially interested in low-float stocks as they are a great way to generate profits at each trading session. The fact that these stocks have a low number of outstanding shares traded makes them highly subject to large upward price change in case or raising demand. This makes them an ideal day-trading investment opportunity especially for investors able to trade large volumes. Low-float stocks have become a widely common and popular amongst day-traders and can be found in all major markets. As previously mentioned, certain catalysts, special events or increased retail interest can drive these stocks to run 50–100% in a single session.
At Edgewall, our algorithms screen markets (NYSE, AMEX, NASDAQ) to help you identify the most promising low-float stocks — from pre-market and throughout the session — so that you can seize their momentum before other traders and develop an edge on the market.
Trading low-float stocks
As we’ve seen, low-float stocks price movements are not necessarily correlated to the company’s fundamental metrics and performance. While they can provide you with a quick snapshot of the company’s health and recent performance, it is very common to see low-float and momentum stocks trade at ratios and multiple very far away from rational financial metrics. Since these stocks move on buying or selling pressure, which drives momentum, it is also important to take a look at technical analysis patterns and set-ups to trade them. Technical analysis will allow you to analyse recent and past price action to derive resistance, support levels, key price inflection points in order to set-up your trades and decide on your trading plan.
What are key indicators momentum traders look at?
Moving Averages (SMA’s): Moving averages allow you to identify key price trends by removing short-term fluctuations and market noise. Moving average lines can be applied for different periods and momentum traders typically look at short-term moving averages like 20-day, 50-day and 200-day MA lines to identify price trends and define key support or resistance levels. Comparing long-term and short-term moving averages is commonly used by traders to interpret short-term trend reversals when they crossover. There are two key types of MA crossovers:
- Golden Cross : occurs when a short-term moving average (50-day) crosses over a long-term moving average (200-day) to the upside. It is interpreted by traders as an upward trend signal. Essentially, the short-term average trends up faster than the long-term average until they crossover.
- Death Cross : occurs when a short-term moving average trends down and crosses the long-term average, signalling a downturn in the market.
Relative Strength Index (RSI): RSI is a popular technical analysis indicator used by momentum traders. It measures the magnitude of recent price changes in a stock price to determine whether it is overbought or oversold. The indicator oscillates between 0 and 100. Generally, an RSI value below 30 indicates that the asset is oversold and deemed bullish while a value over 70 implies the asset is overbought and prone to a trend reversal and price pullback. In momentum trading, during an uptrend the RSI will tend to be over 30 and frequently around 70 or more. On the opposite, during a downtrend, it will be around 30 or less. These metrics can help determine the strength of trends and identify potential price reversals. For instance, if the RSI cannot reach 70 or more during several uptrends, if could mean the trend has weakened and is now reversing to lower levels. The opposite applies to downtrends.
Stochastic Oscillator: this technical indicator tracks market momentum over a specific period of time. It compares a particular closing price of a security to a range of its prices overt n period of times. The idea behind the stochastic indicator is that the momentum of an asset’s price will often change before the price movement of the asset actually changes direction. Hence, the indicator can be used to predict trend reversals. The stochastic indicator is a two-line indicator that you can apply to any charts and varies between 0 and 100, just like the RSI. It shows how the current stock price compares to the highest and lowest price levels over a pre-determined period in the past. The previous period used is usually 14 days (as for RSI). When the stochastic indicator is applied, a white line will appear below the chart. This white line is the %K line. There will also be a red line on the chart, which is the three-period moving average of %K. This is referred to as %D. See below:
When the stochastic indicator is at a high level, it means the instrument’s price closed near the top of the 14-period range. When the indicator is at a low level, it signals the price closed near the bottom of the 14-period range. A reading above 80 signals the asset is overbought while a reading below 20 signals the asset is oversold. Like for RSI, overbought and oversold levels can be useful to interpret trend reversals. While the RSI was designed to measure the speed of price movements, the stochastic oscillator formula works best in consistent trading ranges.
Moving average convergence divergence (MACD): The MACD indicator helps to interpret whether a trend is bullish or bearish. It is calculated by subtracting the 26-period EMA (exponential moving average) from the 12-period EMA. The result is the MACD line. In addition, a “signal” line based on 9-day EMA is plotted next to the MACD line which can be used to trigger buy and sell signals. As shown below, when the MACD rises above the signal line, the indicator gives a bullish signal. Oppositely, if the MACD falls below the signal line, the indicator gives a bearish confirmation. Some traders wait for a confirmed cross above the signal line before entering a position to reduce the chances of entering a position too early.
Why Risk/reward matters
To generate consistent profits on the long-term, Momentum traders must focus on risk/reward to set-up their trades. A simple rule is to never risk more money that you expect to make with a trade. The risk-reward ratio is a calculation of how much you are willing to risk in a trade, versus how much you plan to aim for as a profit target:
A risk-reward ratio of 1:3 means that you are risking $1 to potentially make $3. A risk-reward ratio of 1:5 means that you are risking $1 to potentially make $5. It is generally advised to target a risk/reward ratio higher than 1:2, however, you’ll still need to win on enough trades to break-even and start generating profits. As you can see on the above picture, a 1:2 ratio will require you to win 33% of the trades you make. Ensuring your risk/reward is attractive enough as well as having risk management measures in place is essential to succeed in momentum trading.
How should I set-up my trades?
Momentum trading requires to have a consistent and non-emotional trading approach with the right orders in place to secure gains and limit downside risk.
Take profit target: generally, you will want to set a take profit target at a price point where you expect a trend reversal. You can take a look at the below indicators to set-up your take profit orders:
- Key resistance level: placing a take profit on a recent or intraday resistance level makes sense when the stock price has been trading in a range or in a relatively weak trend. In case of a short position, you can use the support level to place your take profit order.
- Fibonacci extensions: Fibonacci extensions let you project extensions of the current price movement. They are a popular way to establish profit targets based on price level projections If the price moves through one extension level, it may continue moving toward the next.
Stop-loss: it is essential to set-up a stop-loss to protect your capital when momentum trading. Ideally, your stop-loss should not be set too close to your entry-price to avoid being triggered in case of price retracement— which will stop your prematurely and make you miss the upward move you anticipated. If you set it up too low, you will risk more capital and your risk/reward ratio will become less interesting. Below are a few ways to set-up your stop-loss correctly:
- Key support level: very recent or intraday support levels can be used to set-up your stop-loss. Tip: avoid exact values as other traders will probably also set-up their trades at the same level.
- Moving averages: Moving averages are great areas to place your stop losses. Trending stocks will often use MA’s as support or resistance. For day trades we will often put our stops under the 9 EMA or the 20 EMA. It is best to wait until the moving averages catch up and trade near the current stock price so you can lower the risk you have to put on the trade. Be patient and wait for trending stocks to pull back to their moving averages so you can get a better risk vs reward on your entry point.
Note that these take-profit and stop loss orders will need to be adjusted to reflect the price action while trading. We will dive deeper into trade set-ups and these indicators in a follow-up article so watch for our updates.
Conclusion
This article aimed to cover the basics of momentum trading and to provide you with the fundamentals to start trading. It is important to remember that momentum trading requires to act in a non-emotional manner, be disciplined and some practice. Whether you are a new or an advanced trader, sticking to risk management rules is essential not to get burnt and protect your capital.
Key takeaways:
- Momentum investing is a trading strategy in which investors buy securities that are rising and sell them when they look to have peaked. Some traders also open short positions to benefit from trend reversals and pullbacks.
- The aim is to work with volatility by finding buying opportunities in short-term uptrends and then sell when the securities start to lose momentum. Traders then repeat the process.
- Skilled traders understand when to enter into a position, how long to hold it for, and when to exit; they can also react to short-term, news-driven spikes or selloffs. Ensuring that you have the right trading set-up (take profit, stop loss orders) and discipline is key to succeed.
- Risks involved in momentum trading include moving into a position too early, closing out too late, setting stop-loss too close to entry price, and getting emotionally involved.
- Edgewall helps you identify low-float momentum stocks with the highest potential from pre-market and throughout the session so that you can focus on trading and identify opportunities faster than everyone else.
Join Edgewall today!
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