A momentum strategy seeks to profit from buying high and selling higher on the long side while selling low and covering lower on the short side. Most traders fail in this enterprise because they haven’t mastered the five elements of a perfect momentum trade. Once in place, the profit and loss statement can improve dramatically, adding significant capital to the bottom line.
Trading momentum markets require sophisticated risk management rules to address volatility, over-crowding and hidden traps that steal profits. Market players routinely ignore these rules, blinded by an overwhelming fear they’ll miss the rally or sell-off while everyone else books windfall profits. The rules can be broken down into five elements: selection, risk, entry, management and exit.
Proper Security Selection
Choose liquid securities when engaging in momentum strategies. Stay away from leveraged or inverse ETFs because their price swings don’t accurately track underlying indices or futures markets due to complex fund construction. Regular funds make excellent trading vehicles but tend to grind through smaller percentage gains and losses compared to individual securities.
Seek out securities that trade more than five million shares per day whenever possible. Many popular stocks meet these criteria, but even low float issues can turn into highly liquid instruments when news flow and intense emotional reactions draw in market players from diverse sources. You can uncover these plays by applying two simple market scans:
- Stocks that trade at least 75% of their average daily volume in the first hour of the session.
- Stocks that traded at least five times their average daily volume in that session.
Also, keep watch for the flavor of the day, when new products, divisions or concepts capture the public’s imagination, forcing analysts to throw away calculations and re-compute profit estimates. Biotechs and small to mid-sized technology companies create a generous supply of these story stocks, making them excellent choices for the momentum game.
Tight Risk Control
The greedy eye routinely form fits rallies and selloffs, seeing a hundred ways that imaginary positions will book profits while ignoring the shakeouts, reversals and stop running exercises designed to separate the majority of traders from their money. This risk side of the equation must be addressed in detail, or the momentum strategy will fail.
Stick with the most promising setups while passing on the majority of popular plays. Seek out securities with reward: risk ratios of 3:1 or greater, establishing these variables by locating support and resistance that may come into play during the life of the trade. Use Bollinger Bands and relative strength indicators for securities at new highs to estimate how far price can stretch before a countertrend takes control.
Perfect Entry Timing
The best momentum trades come when a news shock hits, triggering rapid movement from one price level to another. In turn, this sets off buying or selling signals for observant players who jump in and are rewarded with instant profits. Another batch of momentum capital enters as the trade evolves, generating counter swings and stop running that shake out weak hands. The hot money population finally hits an extreme, triggering volatile whipsaws and major reversals.
Early positions offer the greatest reward with the least risk while aging trends should be avoided at all costs. The opposite happens in real world scenarios because most traders don’t see the opportunity until late in the cycle and then fail to act until everyone else jumps in. These weak-handed positions incur major losses because they’re sitting in the crowd being targeted by strong hands.
Enter the whole position at once if (1) early in the new opportunity and (2) a stop can be placed close to the entry but behind a support level, like a high/low, trendline or moving average. Scale into the position when a price has already gained considerable ground, adding tranches once the prior piece generates a profit. Move the stop to breakeven as soon it can sit comfortably outside the boundaries of natural countertrend movement.
Position management takes time to master because these securities often carry wide bid/ask spreads, requiring larger movement in your favor to reach profitability while also grinding through wide intraday ranges that expose stops, even though technicals remain intact. Delaying new tranches until price moves far enough to lower the odds of stop running counter-balances this added risk.
Choose your holding period wisely because risk increases the longer you stay positioned. Day trading works well with momentum strategies, but forces players to take larger positions to compensate for the greater profit potential of multiday holds. Conversely, it is best to reduce position size when holding through multiple sessions to allow for greater movement and stop placement further away from the current action.
Exit when the price is moving rapidly into an overextended technical state, often identified by a series of vertical bars on the 60-minute chart or price piercing the third or fourth standard deviation of a top or bottom 20-day Bollinger Band. Tighten up stops or consider a blind exit when technical barriers are hit like a major trendline or prior high/low. Use a relative strength oscillator, like Stochastics or Wilder’s RSI, exiting or taking partial profits when crossovers signal potential trend changes.
Five strategic elements build profits in momentum trading strategies: picking the right security, exercising tight risk control, entering at the right time, managing open position and taking opportune exits.
Alan Farley can be contacted at HardRight Edge