Part of Isaac Newton’s second law of motion says a body in motion remains in motion unless acted on by an outside force, and this covenant of physics has plenty of parallels with momentum investing. Momentum investing isn’t about finding stocks about to pop or drop but riding an established wave until the shoreline comes into view.
Momentum investors tend to have shorter timelines than buy-and-hold investors and use different tools when analyzing stocks. They also take on more risk than traditional investors, so grasping the techniques and tools needed for success is vital. In this article, you’ll learn the inner workings of momentum investing, the benefits and risks of this strategy and how to get started with your momentum portfolio.
What Is Momentum Investing?
If bodies in motion stay in motion, do stocks in an uptrend stay in an uptrend? That’s the theory behind momentum investing, which seeks to profit from trends already in motion rather than predicting reversals or changes in direction. Momentum investors use technical indicators to find stocks with solid trend continuance signals and buy shares to ‘ride the wave.’
The direction of the trend isn’t crucial; momentum investors can buy stocks trending up or down depending on market conditions. The essential data comes from the trend's strength, which is where the term momentum comes in.
How much momentum is in the trend? Is the wave of buying or selling continuing to grow, or is volume beginning to dry up? Long-term investors may not be concerned with volume and trend data, but momentum investors need technical tools and concepts like support and resistance to time their trades.
Momentum trading timelines can be hours, days, weeks or even months. But momentum strategies aren’t meant for investors looking to ‘set-and-forget’ their portfolios. Momentum traders must stay on top of the data and have the agility to exit a position should the charts sway from the thesis.
How to Get Started with Momentum Investing
Momentum investing isn’t a secret sauce used by pros and institutions. All you need to get started is capital and a trading account. But to successfully trade momentum, you’ll need a comprehensive understanding of a few technical indicators and a well-devised trading plan to keep your emotions from interfering with the process.
Set Up Your Trading Account
You’ll need a brokerage account to trade stocks, but not all brokers provide the same services. Momentum trading requires utilizing charting tools, indicators and different order types, so select a broker that offers the features you need.
What should you look for in a broker? To start, you’ll want a robust trading platform; pick a broker with an intuitive interface, functional mobile app and the ability to buy and sell a wide range of securities. And while most firms today offer commission-free stock trading, there’s still a schedule of fees to compare when selecting a broker. The more suitable your broker, the better experience you’ll have trading stock online.
Use the Right Tools and Indicators
Once you’ve chosen a broker and opened an account, you’ll need to familiarize yourself with the tools of the momentum trade. Moving averages are a crucial component of many momentum indicators since they help smooth out price data over short timeframes to identify trends better. For example, if a stock is trading above its 50- and 200-day moving averages, that’s evidence that the uptrend has room to continue.
You’ll want to learn how to use continuation-spotting tools like the Relative Strength Index (RSI) in your research. The RSI uses short-term daily highs and lows of a specific asset price to measure the velocity or strength of a trend. Readings between 30 and 70 on the RSI scale indicate the trend is likely to continue. Other critical technical indicators include the Moving Average Convergence Divergence (MACD) and Average Directional Index (ADX).
Develop a Trading Plan
Momentum investing requires a plan tailored to your specific goals. Your risk tolerance and investing timeline will play a prominent role in deciding which assets you trade and how long you hold them.
Before opening any positions, set profit goals and loss limits. If you plan to take profits after a 20% gain beforehand, you’ll be less inclined to make a potentially poor decision by hanging on. Also, consider your ideal entry and exit points before buying shares, as short-term trading strategies require precision for maximum gains.
Monitor and Adjust Your Strategy
Remember that Mr Market tends to laugh at our carefully laid plans. Momentum trading plans shouldn’t be static, and you must be ready to pivot if the market or economic environment changes. Many market prognosticators called for a recession in 2023; when that didn’t materialize, the investors who quickly pivoted to buying tech stocks were rewarded.
Short-term trading strategies require a more watchful eye than long-term ones. Momentum traders constantly review their charts, consume financial news and chat with other traders to confirm or adjust their views. Market conditions can change quickly, and stubborn investors won’t last long using momentum techniques.
Risks and Limitations of Momentum Investing
Newton’s second law of motion has a crucial caveat: “unless acted upon by an outside force.” Unfortunately for investors, outside forces are plentiful in markets and the economy. Since momentum investors have shorter timelines than long-term investors, risk increases because volatility, trend reversals or geopolitical events don’t happen on a tidy schedule.
RSI or MACD won’t be able to tell you about military action in Europe, an oil shortage in the Middle East or changing trends in the U.S. presidential election. And if experts using Stephen King-length novels of data can’t make accurate predictions, how can we expect to have a 100% success rate in trading?
Technical analysis is practical, but it doesn’t have a perfect track record of predicting trend continuations or reversals. A careful investor using multiple indicators must be aware of false signals and use proper risk management tools to minimize losses. And while every investment involves some type of risk, momentum trading requires a different level of supervision since volatility can be unpredictable.
One of these risk management tools is the stop-loss order, which prevents a position from dropping below a certain level by automatically triggering a sell order. For example, if you buy 100 shares of GameStop Corp. (NYSE: GME) to ride a wave of upward momentum, you might want to set a stop loss order 10% below your entry price to prevent significant losses in a trend reversal.
If the share price continues to move upward, you can also increase your stop-loss order (or use a trailing stop order to automatically increase your exit point).
Conclusion
Momentum investing is a short-term trading strategy that rides strong trends. Traders using this technique utilize technical indicators like RSI and MACD to measure trend strengths and open positions in stocks with the most robust trend. Momentum trading is a popular strategy for institutional and retail investors but requires a strong stomach for risk and comprehensive knowledge of technical analysis.
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