What is Momentum Trading: Meaning, Strategies, & How It Works

When an investor buys a stock or other asset when its price is rising or has moved significantly, this is called momentum trading. The goal here is to profit from the short-term, foreseeable changes in financial asset prices. Technical analysis can be used for this, and it is common to compare it to trends in more traditional investment markets, like those for currencies, bonds, and commodities.

What is momentum trading?

What describes momentum trading is when asset prices are steadily rising, and an investor enters the market and trades in those assets to capitalise on the rising trend. This trading strategy uses the trend trading framework to assist investors in analysing price movements. 

How momentum trading works?

Below are the steps that can be followed to start your momentum trading:

• Identify stocks that are experiencing strong upward momentum. 
• When a stock breaks above a specific moving average, enter a position. 
• Set entry points slightly higher than the moving average to capitalize on potential gains. 
• Stop-loss orders help to limit potential losses. 
• To maximize profits, set exit points above the moving average.

What’s the right time to start momentum trading?

Mornings, particularly the first hour after market open (9:30am - 11:30am), are almost always the best times to trade momentum strategies. This is the peak of the market's volatility and trend. All you have to do is look for stocks that have a strong daily chart above key moving averages and no nearby resistance levels. Because this implies the momentum is likely to continue.

When you identify stocks with high relative volume, such as 2X their average, it indicates increased interest and participation, which is driving the momentum.

While trading, do know that time entries coincide with a catalyst, such as news, earnings, or a technical breakout. Events like this trigger rapid price movements that you can capitalize on as momentum traders.

Note: Avoid trading in the middle of the day (after 11:30am) as the market can become more choppy and less trending. The key is to identify stocks with clear momentum early in the trading day and time entries to take advantage of the strongest part of the trend. Proper risk management, such as using tight stop-losses, is also crucial for successful momentum trading.

Momentum Trading: Strategy for Day Traders

Day traders and momentum trading strategies go hand in hand because momentum trading is particularly well-suited for day traders. As day traders aim to profit from the short-term movements of assets, and momentum trading helps them achieve this by focusing on the recent strength of price trends.

This risk management aspect is critical for day traders, as investors protect their positions from adverse market movements. And momentum trading thrives in high-volatility markets, which is common in day trading. Day traders often look for volatile markets to take advantage of short-term price movements, and momentum trading helps them identify and capitalise on these trends.

Day traders use various technical indicators and chart patterns to identify and confirm trends, making momentum trading a natural fit for this approach. As you know, momentum trading strategies often involve setting tight stop-losses and managing positions to minimise losses. 

How Do Stock Scanners Help in Finding Momentum Stocks?

Based on the search results, stock scanners are very helpful for finding momentum stocks in the following ways:

• Identifying Trending Stocks: Momentum trading relies on identifying stocks that are in a strong upward or downward trend. Stock scanners can be configured to look for specific technical indicators like moving average stocks, MACD, and RSI that signal the presence of a sustained trend.
• Screening for Volatility and Volume: Momentum stocks are characterized by high volatility and trading volume. Scanners allow you to set filters for percent price change, average daily trading volume, and other metrics to surface the most actively traded, volatile stocks.
• Scanning Across the Market: Rather than manually reviewing individual stocks, scanners can quickly analyze thousands of tickers to find the ones exhibiting the strongest momentum characteristics across the entire market or within specific sectors.
• Automating the Process: Manually trying to identify momentum stocks is time-consuming. Scanners automate the process, allowing you to quickly generate a list of potential momentum plays that you can then research further.
• Monitoring for Changes: Momentum can shift rapidly, so scanners allow you to continuously monitor the market and get alerts when stocks meet your momentum criteria, ensuring you don't miss opportunities.
• Backtesting and Optimization: Many scanner tools let you test your momentum strategies against historical data to fine-tune your parameters and improve your chances of success.

Alternate Trading Methods

If momentum trading is not your preferred method, you can explore other types of trading.

Conclusion

It's important to keep in mind the risks and potential for profit associated with momentum trading. By carefully considering risk management strategies, personal goals, risk tolerance, and market circumstances, traders can make informed decisions and work towards achieving success in this approach.

FAQs