Why Momentum Trading Strategies Work

Why Momentum Trading Strategies Work As you have probably heard by now, “buy low, sell high” is one of the most popular phrases used by Wall Street investors. Though this particular principle has proven itself to be quite sound, it is still just a general guideline. When it comes to successfully trading on the stock market—whether you are investing in the NYSE, NASDAQ, or elsewhere—the real challenge is identifying which underpriced stocks actually have the potential to increase in value.

Naturally, there are many different approaches you can use when investing in the stock market. One of the most popular approaches used today is frequently referred to as momentum trading. ​This strategy seeks to exploit the natural volatility existing in the market and, as frequently quoted by momentum trading advocates, is largely centered on the principle of “buying high and selling higher.”

In this article we will discuss the most important things for you to know about momentum trading and how you can effectively implement a​ ​momentum trading strategy​. The reason why this particular trading strategy is so popular is that it allows you to effectively manage your exposure to risk while simultaneously maintaining your portfolio’s potential to earn a return on your investment. Though no returns can ever be guaranteed, ​taking the time to understand this unique approach to stock trading can help you potentially increase your earning potential.

What is momentum trading?

As stated, while traditional stock traders will usually claim the need to “buy low, sell high”, momentum traders will advocate to “buy high, sell higher.” Though both of these approaches rely on assuming a position right before a stock price is about to increase, the difference between these strategies is ​when ​the position is actually assumed.

Essentially, a momentum trading strategy is one that involves assuming a long position as soon as stock price has begun to increase or assuming a short position as soon as the price is about to decrease. This strategy was largely pioneered by Richard Driehaus, who ultimately became one of the most successful fund managers of all-time.

Momentum traders recognize that the market is naturally volatile and stock prices will experience a variety of ups and downs throughout the business cycle. Suppose that the “correct” value of a given stock were $10 per share and that the stock price fluctuates between $8 and $12 over time. While the stock price is dropping, the momentum investor will wait for the price to “bottom out.” Instead of investing as soon as the stock price is below the objective market value (<$10), the momentum investor will wait for the price to have actually begun an upward swing. Though this strategy indeed requires

investors to carefully and consistently monitor changes in price, it has proven itself to be very effective.

What are the benefits of using a momentum trading strategy?

Momentum trading strategies—like most trading strategies—are implemented with the hopes that risks can be minimized and rewards can be maximized over time. · High potential for short-term earnings. ​Using the example listed above, suppose that a stock has consistently demonstrated price volatility ranging from $8 to $12. Once the stock price has risen from $8 to $8.25, a momentum trader might recognize that it is experiencing a natural upswing that may go as high as $12. In this particular situation, entering at $8.25 and exiting at $11.75 will earn you a 42% return on your investment. · The ability to exploit natural volatility. ​Momentum traders recognize that both positive and negative movements will inevitably occur—the goal of momentum trading is to enter the market once movement has occurred (minimizing risk), but before the bulk of investors have recognized this movement. Though the window to successfully employ this strategy may be relatively short, the opportunity to exploit market volatility will undeniably exist. · Outsmarting other investors. ​Despite the fact that many of the principles of investing are quite well-known, many investors make emotionally—rather the quantitatively rational—investment positions. Momentum trading is unique because it makes it possible for you to specifically take advantage of the decisions of other investors.

Momentum trading strategies can be justified by​ ​natural market patterns​, observable price tendencies over time, and consistently high rates of returns.

What are the most important indicators for momentum traders to follow?

Naturally, if you hope to succeed as a momentum trader, you will need to be able to correctly identify when it makes sense to enter a position and when it makes sense to exit a position. In order to do this correctly, there are a variety of different indicators that will be important for you to pay attention to. · Asset Liquidity: ​because momentum trading is a relatively short-term trading strategy, you should focus on assets that will be easy to dump when necessary. Usually, daily trading volume is a strong indicator of a stock’s overall liquidity. · Reversals: p ​ rice reversals will be the most important indicator for momentum traders to pay attention to. As soon as the stock reverses its positions—in other words, it has lost its ​momentum— ​ then it will be time for you to make a hard exit.

· Open and closing prices: u ​ sually the largest change in price that a stock will experience will be between its closing and opening positions. Holding onto a stock overnight is generally considered to add risk to momentum trading strategies. · Moving averages: p ​ aying attention to how a particular stock has been moving over time can help you identify when entering or exiting a position may be most appropriate.

Developing a successful strategy will involve not just focusing on a single metric, but focusing on the market as a ​comprehensive whole. ​The more you can understand about how a stock’s price tends to move over time, the more likely you will be able to effectively execute trades.

How to Successfully Implement a Momentum Trading Strategy As you can probably see, effectively implementing a momentum trading strategy is quite possible, but will still require you to pay careful attention to certain details. · Recognize the cost of trading: ​when calculating your return on investment, bid-ask spreads and possible broker fees will both need to be accounted for. · Assume both short and long positions: i​ n order to decrease your exposure to general market risk, you should assume both short and long positions while still using a momentum trading strategy. · Use stop trading: i​ nstalling stop trade orders can help you avoid holding a position for too long (thus helping you minimize your exposure to risk). · Mind your position size and holding period: ​naturally, the longer you hold a position or the larger that position might be, the more you will have to gain or lose.

Taking the time to read introductory trading guides—such as this one and many others like it—will also help you familiarize yourself with momentum trading strategies as a whole.

Conclusion Momentum trading is a unique approach to the stock market that has proven to have a wide variety of benefits. Generally speaking, momentum traders seek to assume a position as soon as it has become clear that a stock is moving in a specific direction.

Though there are many indicators you will need to pay attention to as a momentum trader, it can certainly help your portfolio improve its overall earnings potential.