Key Points
- Momentum investing is a short-term trading strategy that capitalizes on price movements and continuing trends.
- Momentum investing can produce short-term profits with less fundamental research but may also come with a higher risk of loss.
- To protect capital, investors should use a stop-loss order when momentum trading, which automatically exits the trader's position if a certain level of loss is realized.
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Momentum trading is a short-term strategy that capitalizes on price trends and movements. In short, momentum investors look for stocks that are increasing in value and predict whether the trend is likely to continue. If they believe it is, the investor may enter the market to sell shares after they increase in value quickly.
While momentum investing can produce profits, it’s a riskier trading strategy. Read on to learn more about momentum trades and how to execute them.
What is Momentum Investing?
In physics, “momentum” refers to continued and intensified movement in the same direction. For example, a train speeding right will continue to move right until the conductor applies the brakes or if another force acts upon the train that alters its course. Even if the train's conductor engages the brakes, the train is likely to continue moving right due to the power of the momentum it had built throughout its journey.
The basic idea of momentum is the key idea behind momentum factor investing. Investors look for stock shares showing above-average positive price movements or another key technical indicator showing that the trend showcased is likely to continue. The idea behind momentum trading is that positive price movement trends will likely continue after the pattern has been solidified. Traders may then buy shares of stock and quickly unload them after the price has increased, trading more off the stock’s media sentiment and popularity rather than its underlying fundamentals.
A Deeper Dive into Momentum Investing
While some investors may create a list of momentum stocks they return to multiple times a week, most momentum traders focus on short-term price movements over fundamentals. When selecting momentum investments, most traders don’t spend much time researching factors like long-term stock prospects, leadership and position within the global economy that might contribute to the longevity of these stocks. Instead, a momentum trader will look for technical indicators related to the momentum itself, which may result in purchasing less stable long-term picks.
This can make momentum investing a risky trading strategy. Momentum investors usually do not spend much time researching company fundamentals, instead focusing on sudden and unusual price movements. This might put investors in a position where they purchase shares of companies without the structure to withstand the test of time. If investors hold these shares too long, they could lose money when the market corrects itself.
What Do Momentum Investors Look for?
Momentum investors may look for technical indicators when selecting stocks for momentum trading, including common options:
- Relative strength index (RSI): RSI is a common technical indicator used in momentum investing, describing the speed and change of price movements. Individuals can use it to determine whether a stock is overbought or oversold. RSI is usually calculated over 14 days, with values over 70 indicating that a stock might be overbought, presenting a momentum investing opportunity.
- Moving Average Convergence Divergence (MACD): MACD is a technical indicator that uses two price calculations to determine if a trend is likely to continue. Momentum investors chart two exponential moving averages calculated over different time periods. A price movement trend is statistically more likely to continue if the lines intersect, indicating profit potential.
- Rate of change: A stock’s price is the difference between share values, calculated over a specific period. Many investors use 10-day periods to evaluate price changes.
Unlike other technical indicators, you don’t need to memorize a complicated formula to calculate market momentum. The formula to calculate market movements for a momentum trade is as follows:
M = P - P1
Where:
- M: Market momentum
- P: The latest asset price
- 1: The closing price of the asset during the beginning of the time period measured
Depending on your trading strategy, you may need to calculate market momentum multiple times throughout the day. Technicians usually use a 10-day time frame when measuring market momentum.
Momentum Trading Strategies
Now that you understand the basics of how to trade momentum stocks and how this trading strategy works in theory, let’s take a closer look at the specific indicators investors may look at when deciding which assets to buy. The following are some major momentum investment strategy options you might see as you learn more about the market.
Highs
One of the first technical indicators that an investor might look for when learning how to invest in momentum stocks is price discovery. While it might seem risky to invest in continuously growing stocks, some evidence suggests that price trends tend to continue due to the momentum movement behind them.
Use a stock screener to look for stocks trading a certain percentage above their previous high. Many momentum traders look for stocks and ETFs trading at least 10% above their previous high when narrowing down their investment options.
Momentum traders may use highs as the basis of their trading strategy but combine this indicator with other technical data points that indicate the likelihood that the trend will continue.
For example, a momentum trader might identify stocks trading at their high first before looking at average daily trading volume to set their price target.
Volatility
Some investors may use volatility as their base technical indicator when identifying which stocks could be potential momentum plays. Volatility measures how much a stock deviates from its opening value on average throughout the trading day.
Stocks with higher volatility tend to fluctuate in price regularly, reaching new highs and lows weekly. These stocks also tend to have lower per-share prices, which can appeal to penny stock investors.
Price Trends
Before selecting stocks to momentum trade, it’s important to look at price trends and how likely they will continue. To accomplish this, investors may look at where the stock opened and ended for the past few days or weeks before choosing a point to enter the market. They may also look at volume over the past few days to see if the price trend is likely to continue long enough to capitalize on it. If volume increases, a price trend may be more likely to continue.
Example of Momentum Investing
To illustrate how to momentum trade, let’s look at an example from the recent Gamestop NYSE: GME bull run that shocked investors. After years of the stock slowly decreasing in value, investors were able to identify a short squeeze opportunity, buying and holding the stock en masse. This caused the price of Gamestop stock to surge, reaching an all-time high value of around $325 per share in January 2021.
While Gamestop has undone most of the growth seen during this time, some investors were able to capitalize on the quick, sudden price movement over the month. For example, Gamestop’s bull run began around January 15, 2021, when shares were trading at about $9.54.
Momentum surrounding the hype of the Gamestop short squeeze fed into the price frenzy, causing the price trend to continue through January 26.
Momentum investors initially did not need to get in on the Gamestop to see a profit. On January 25, shares of Gamestop stock were trading at an average of $23 and fluctuated in price throughout the day. A momentum investor might have noticed the unusual trading activity on GME at this point and entered the market, purchasing 100 shares at $23 for a total spend of $2,300.
Riding the momentum trend, the investor might use a market order to sell their shares as the stock price increases. A market order is a type of stock order that executes at the most advantageous time for the seller or buyer based on their position in the current market. The investor might also set a limit order after determining a price target.
Imagine that the investor set a price target of $27.60 per share — 20% higher than the price that they purchased at. This price was reached on the same day as the purchased shares, meaning the investor would exit their position relatively quickly after entering. In this example, the investor would see a total profit of $460 by selling shares at a 20% premium during the buying frenzy.
Risks and Benefits of Momentum Investing
Is momentum investing a viable strategy? While it’s possible to profit from momentum trading, this strategy is more risky than long-term investing strategies that require buying and holding. Some potential benefits you could see when momentum investing could include the following.
- Profit potential: One of the primary benefits of momentum trading is the potential for significant profits. By identifying assets with strong upward momentum, traders aim to capitalize on short to medium-term price trends and capture price appreciation. Instead of spending hours researching a company’s fundamentals, momentum traders take a short-term strategy and purchase assets to sell them quickly.
- Reduced fundamental analysis: Momentum traders focus more on price action and technical indicators than on extensive fundamental analysis. This can make the trading process more straightforward and less time-consuming than other strategies requiring in-depth research.
- Adaptability: Momentum trading can adapt to various market conditions. Traders can seek opportunities in rising and falling markets, as the strategy allows for short selling or taking bearish positions.
It’s important to remember that the momentum strategy is best suited for short-term, active investors. This investing strategy also comes with risks that you must consider, including the following.
- Trend reversal potential: While momentum may often cause a stock to continue increasing or decreasing in value, this is not always true. One of the most significant risks of momentum investing is the potential for reversals and whipsaws. Just because an asset has exhibited strong recent performance does not guarantee that it will continue to do so. Momentum can reverse suddenly, leading to losses if caught on the wrong side of the trade.
- Overvaluation risk: Momentum investors often buy assets that have experienced significant price increases. This can lead to overvaluation, where the asset's price exceeds its fundamental value. Overvalued assets are more vulnerable to corrections or price declines, potentially producing quick and sudden losses.
- Loss of profit associated with trading costs: Momentum investors may frequently buy and sell, which can result in high turnover and transaction costs. These costs can eat into profits and reduce overall returns. If you’re considering momentum trading, it can be helpful to look for a broker that offers $0 commissions.
In momentum trading, these stocks usually do not produce the best returns when held long-term. Have an exit strategy before entering the market to preserve your capital in the event of loss. Even the most experienced trader cannot predict price movements accurately 100% of the time.
Does Momentum Trading Work?
While momentum trading can produce profits, it’s not for everyone. This stock trading strategy requires vigilance, with the most successful investors planning their entry and exit points before placing their first order. If you decide to try your hand at momentum investing, be sure to use safety features like a stop-loss order to limit your loss if you incorrectly predict a stock’s movement.
You must also know pattern day trader rules affecting all short-term sellers and scalpers. Under the pattern-day trader rule, you are defined as a pattern-day trader when you execute four or more "day trades" within five business days. Once you become classified as a pattern day trader, you must maintain a balance of at least $25,000 in your trading account between cash and assets. If you dip below this requirement and fail to bring your account back to the minimum balance, you could see your ability to trade restricted in the future.
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