Momentum trading is a way to profit from short- or intermediate-term moves in the market. To be successful at it, you’ll need a lot of skill, time and potentially money, and you’ll need a hefty tolerance for risk.
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But successful momentum investors can make large profits over a relatively short period of time, and it certainly makes the investment process more exhilarating. Here’s a look at what momentum trading is, how it works, and the pros and cons involved so you can decide whether it’s something you want to try.
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Momentum trading is a strategy in which investors try to profit from sharp moves in the market.
Unlike long-term investing, which can involve months or even years of waiting for a stock to make a move, momentum traders wait until a stock, index or market is already in motion before jumping in and trying to capitalize.
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Both day and swing trading can be considered subcategories of momentum trading. Generally, momentum investors stay with a trade for the intermediate term, which is more akin to swing trading, but some momentum investors want to get in and out as quickly as possible, making them day traders.
You can think of momentum trading as more of a strategy, while day trading and swing trading refer more to the time that momentum traders are in the market.
The best momentum trading strategy is to jump into a position the moment that market-moving news strikes. For this reason, many momentum traders invest in expensive software or news services that alert them immediately to any potential market-moving action so they can invest.
One momentum strategy is getting into positions based on unexpected earnings results, either positive or negative, which momentum investors can do by getting ahead of the mass traders that will pile into or out of a position. For example, if a volatile stock posts better-than-expected earnings, it could move up 10% or more in a matter of moments. A successful momentum trader will be notified about the results the second they arrive and may even have an automated investment program that will get them into the stock before it makes the bulk of its move.
Another momentum investing strategy is to wait until a stock is in a confirmed uptrend and then ride it until it breaks technical support. This is more of an intermediate-term strategy that doesn’t require an on-the-spot decision, so it can be less stressful for some traders.
Equally important for all momentum traders is to understand or be notified the moment that a positive or negative trend reverses course. If a stock gets extremely extended in a technical sense on the upside, for example, a momentum trader will be waiting for the moment that more sellers than buyers jump into the market, giving them an indication that it’s time to get out of their trade before the stock makes a massive move downward.
Other momentum traders ride the daily ebbs and flows of the market as a whole on a very short time frame. This can require intense market watching and advanced software, but as soon as a surge upward or downward begins reversing, these traders can take advantage of that indication by jumping in or out of a trade.
The primary benefit of momentum trading is that you can potentially make a large amount of money over a short period of time.
If you buy and hold a stock, for example, even a long-term winner may have months or even years in which it doesn’t move hardly at all or even trades at a loss. Rather than waiting for these types of trades to become profitable, momentum traders typically jump in when an investment is already in a trend.
Another benefit of momentum investing is that you can take advantage of the emotional habits of investors, who tend to oversell bad positions and overbuy good ones. Most investors tend to continue buying stocks in an uptrend and selling those that are losers. These emotional patterns make it easier for momentum investors to ride along once a trend has been established.
The main risk to momentum trading is that you can lose a lot of money in a short period of time. If you read a trend the wrong way, you can get burned quickly.
Momentum trading also involves a lot of time and effort. Unlike long-term investors, momentum investors must keep constant watch on their portfolios to make sure a trend hasn’t reversed.
Taxes can also be a problem for momentum investors, who typically make shorter-term trades. Short-term investment gains are taxed at ordinary income tax rates instead of the more favorable long-term capital gains rates, which apply to positions held for more than one year.
Momentum trading involves a high level of risk and is not for every investor. If you’re a fervent market watcher and are willing to invest in software or other electronic aids that can help notify you of forming or reversing market trends, it may suit your investment style and risk tolerance. However, for the average investor, momentum investing is generally too stressful, time-consuming and potentially expensive to be worthwhile.
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This article originally appeared on GOBankingRates.com: Momentum Trading: What Is It, and Is It the Right Strategy for You?
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