Investing > Momentum Trading Explained

Momentum Trading Explained

If a stock’s going up today, will it continue going up tomorrow? Learning about momentum trading can help you find out.

By
Reviewed by
Updated January 13, 2022

All reviews, research, news and assessments of any kind on The Tokenist are compiled using a strict editorial review process by our editorial team. Neither our writers nor our editors receive direct compensation of any kind to publish information on tokenist.com. Our company, Tokenist Media LLC, is community supported and may receive a small commission when you purchase products or services through links on our website. Click here for a full list of our partners and an in-depth explanation on how we get paid.

Have you ever wanted to be a trendsetter? 

Let’s face it – while some of us might want to call the shots on what the next hot band or clothing line is, a lot of us try to keep up with trends as they’re happening. Some of us might even realize three weeks later that suddenly all our friends are talking about some movie, and see it just in time for them to all move on to the next movie.  🎬

In the stock market, traders usually want to buy low and sell high. This requires predicting what stocks are going to pick up, and those predictions can be really hard to get right. But what if there was a style of trading that allowed you to follow trends that are already happening, just like you (maybe) do in real life?

That’s where momentum trading comes in. Momentum trading involves buying and selling in reaction to ongoing trends. Whether you’re looking to cash in on the momentum of commodities and cryptocurrencies, or want to ride the wave of crowded momentum stocks, this guide can help you determine whether momentum trading is right for your style of investing. 

What you’ll learn
  • What is Momentum Trading?
  • How Momentum Trading Works
  • Best Momentum Indicators
  • Advantages of Momentum Trading
  • Drawbacks of Momentum Trading
  • Momentum Trading Tips
  • Conclusion
  • Get Started with a Stock Broker

What is Momentum Trading? 📚

The stock market is always changing. Whether it’s a dip in the market following a mixed end-of-year job report, or added pressure as bond yields hit a pandemic high, the one thing you can expect from the stock market is that it won’t be standing still. 

Momentum trading is a way of taking advantage of these market swings for your gain. The basic assumption of momentum trading is that if a stock is going up, it will probably keep going up; and if a stock is going down, it will probably keep going down. 

Of course, this is not an ironclad rule—stocks can have short-term peaks or losses, whether that’s because Redditors are trying to push AMC stock upward again, or a plummet in Peloton stock after a Sex and the City character died after a 45-minute ride.

Momentum Trading
Example: Peloton (PTON), the exercise equipment manufacturer, gained a lot of momentum when the pandemic started, but it’s sales dropped after a year, and the bubble burst. Image by TradingView.

But sometimes, if a stock has been going up, that means the company is on the rise and onto something big, and the stock will continue going up. This is where momentum traders enter the picture.

Momentum trading might be holding short-term positions like you do in day trading, or it might have you holding your positions over a longer-term uptrend. Either way, as soon as the stock starts showing signs of falling in price again, that’s when a momentum trader sells.

If you’ve heard of trend following before, you might be thinking momentum trading is a little similar. Yes and no. Both of these strategies look at the price of a stock to make decisions, and have traders buying low and selling high. 

But while trend following really just looks at the price action and volume, momentum trading uses elements of fundamental analysis to time sales. Let’s get into the actual strategies of momentum trading to clarify this difference. 

How Momentum Trading Works 👷‍♂️

So you get how the market works, you’re set up with one of the top stock brokers, and you think momentum trading might be right for you. How exactly do you get started? 

Just like with any strategy for trading stocks or forex, it’s important to understand how you’ll be managing your risk. In momentum trading, there are a few key factors to consider in how you go about making your trades to increase your chances of success. 

To walk through these steps, let’s use a fictional stock called Bob’s Lemonade Stand, or BLS. We’ll walk through when to buy and sell your shares of BLS from a momentum trading standpoint. Let’s get started! 

1. Pick A Good Security for Momentum Trading 🎯

First, it’s important to understand that not all securities are going to be the right fit for momentum trading. How do we become sure that Bob’s Lemonade Stand is the right fit for this strategy? 

The stock market is driven by human nature—and momentum trading has been a way of navigating this since the 19th century. When you’re looking for the right security, you want to make sure that it is a stock whose price actually matches the underlying indices that you’ll be analyzing. This means that leveraged or inverse EFTs are not good options for momentum trading, because there are a variety of complex factors that determine their price. 

So what do you want? Securities that trade over 5 million shares per day tend to be good fits for momentum trading. Regular funds are also good vehicles for trading, even though they have smaller fluctuations. 

You’ll also want to keep an eye out for short-term bursts in certain stocks. For example, if our fictional BLS announces a new product or is endorsed by a high-profile celebrity, that might boost its stock, either temporarily or over the longer term. Stocks are often bolstered by events that get public attention, so watch these and see how you can profit off their gains. 

So, if we’re deciding to invest in BLS for momentum trading, that’s because it: 

  • ☑️ Trades at least 5 million shares per day 
  • ☑️ Is a regular security whose price correlates to its underlying indices 
  • ☑️ It’s on an upswing, and we understand whether that’s due to short-term news or longer-term company growth 

But what if you don’t have a security in mind, and want to search for good options for momentum trading? One strategy is to search for stocks that are trading within 10% of their highs over a recent period. You can check for highs over the past week, month, or year to spot trends that are either just emerging or well-established. 

2. Manage Your Risk 🎚

When you’re investing in securities, whether it’s short- or long-term, there’s always an element of risk. There are tons of ways to hedge in forex and in stocks, but there are some specific strategies that you’ll want to keep in mind for momentum trading. 

First, make sure that you are not opening your position too soon. You want to be fairly confident that the stock is actually on the rise. BLS might be on an upswing, but zoom out—is this just a minor fluctuation, or the beginnings of real momentum? 

You also want to make sure you don’t get out too late. Once the momentum has faltered, it’s time to sell and get out of there. If you wait too long to get out, you could be selling at a new low, which is not what you want. 

If you’re going to be a momentum trader, you need to make sure you have the time to put into it. You’ll need to monitor your investments to see when the trend starts to change, and stay on top of news that could cause a downturn in your stocks. If you’re day trading, you want to avoid leaving positions open overnight, when all kinds of factors can make your stock price change unexpectedly. 

3. Pick the Right Timing ⏲

So, we know how important it is to buy at the right time. But how do we know the right moment to invest in BLS once we see when it’s on an upswing? 

Ideally, we’re going to wait until there’s a big spike in the BLS price, and jump on that. The thinking here is that everyone sees this big spike – and other people are going to be thinking (like us) that this is where the party’s at. The upward momentum will therefore cause more upward momentum, and we’ll have a big payday. Eventually, that momentum will falter – and that will be our time to get out.

The earlier we get in on an upswing, the better. If BLS has been slowly trending upward over several months, it’s possible that it’s still worth buying. But if that upswing was triggered by a discrete event with no followup, it’s possible you’re looking at the end of a trend. Instead, wait for a new event to trigger upward momentum, and pounce on that as soon as possible.

This is why monitoring the news is an important part of momentum trading. There are certain events (such as positive earnings reports, new product announcements, new partnerships, and more) that are likely to trigger upward momentum in a stock price. If you know how to look for these, you can scan the newspapers (or sites, more realistically) instead of just scanning the same old stock charts for hours on end. 

4. Manage Your Position 👨‍🏫

Now that you’ve invested in BLS, it’s time to manage that investment. Unlike traditional investing, you’re not necessarily just going to sit around and wait for the company to take off. You should be actively monitoring your investment and keeping your eye out for the right moment to jump ship. 

Make sure you know what kind of increase you need to see in order to make a profit. This means understanding your bid/ask spread, which is set by your stock broker. If you have a wide bid/ask spread, you’ll need the price to go higher before you even break even. 

The longer you stay in the position, the greater your risk. This is why many momentum traders are day traders, and just ride the fluctuations of a given day. However, with the greater risk comes greater potential reward. If BLS is indeed on a significant upswing, holding the position for longer could yield greater profits. However, holding positions overnight brings added risks.

5. Choose a Good Exit 💰

After hours, days, weeks, or maybe even longer, the momentum you’ve ridden with BLS will come to an end. But how do you choose the right time to sell? 

There are a variety of indicators that will tell you a price reversal is coming. When you see one of these, that means it’s time to get out—before your price falls too far. We’ll share the top indicators for use in momentum trading below, so you can decide the perfect time to sell your shares of BLS. 

Best Momentum Indicators 🏆

There are a ton of technical indicators for forex and stock trading that can help you predict when price changes are about to happen. For momentum trading, you want to know when a trend reversal is coming – whether that’s confirming the start of upward momentum so you know when to buy, or the beginning of downward momentum so you can exit your position. 

Relative Strength Index (RSI) 📊

The Relative Strength Index (RSI) tells you whether a security is overbought or oversold. If it is overbought, that means its price is likely at a high point, and it will go down from here. If it is oversold, that means the price is at a low point, and buyers will soon start driving the price higher again. 

If the RSI is under 30, that means the market is oversold – that’s a good time to buy, or enter a long position. If the RSI is over 70, that means the market is overbought – that’s a good time to sell, or enter a short position.

Relative_Strength_Index
The RSI will be high during strong upward trends, and a sharp drop will usually indicate that it’s a good time to sell. Image by TradingView.

Moving Averages 📈

Moving averages essentially allow you to “slow down” the fluctuations of a price so you can see how the trendline is moving over time. A simple moving average (SMA) shows you an asset’s closing price over a certain number of days. Traders will often look at 50-day and 200-day averages.

Moving Averages
Simple moving averages can be used to confirm bullish and bearish trends. Image by TradingView.

By comparing these two averages, we can confirm whether the security is actually at a high or low point. In momentum trading, we want to make sure the security is trading high as a way of confirming its upward momentum before we buy.

If the 50-day moving average goes above the 200-day average, that means the price is at a high point. If the 200-day average goes above the 50-day average, that means the price is low. 

Bollinger Bands 🎛

Bollinger bands can help you determine when to sell. This indicator is also based around moving averages. Basically, when you are looking at Bollinger Bands, you are looking at the moving average, plus a standard deviation of the price changes over a certain period of time. This creates a little bubble, or “band,” around the moving average that shows you “typical” price fluctuations.

Bollinger Bands
When the price of an asset goes outside the range of the bands, it is an indicator that the price is unstable and might turn around soon. Image by TradingView.

If the price breaks above or below these bands, that indicates a price reversal is coming. When the price reaches the upper band, that’s a good time to sell; when the price reaches the lower band, that’s a good time to buy (usually, but not always). 

The width of the bands also shows you how volatile the market is right now. Bands that are very close together indicate a fairly stable price, while bands that are far apart indicate higher volatility. 

Advantages of Momentum Trading 🌟

Momentum trading can get you big profits in the near-term. Rather than waiting for your investment in Bob’s Lemonade Stand to pay off, you can ride a particular wave, cash out, and buy yourself something pretty. (Or pay rent or whatever—we don’t know what you’re in this for.) 

It’s also a useful trading strategy for a volatile market. When you’re wondering if inflation will lead to a 2022 market crash or how the market will swing from rising energy prices, it’s helpful to have some strategies that actually do well in volatile conditions in your back pocket. 

Finally, momentum trading looks less at the merits of actual companies, and more at how humans respond to news and events. If this is more your comfort zone, momentum trading is a great choice for you. 

Drawbacks of Momentum Trading 🚧

However, no strategy is perfect, and that includes momentum trading. When you’re executing a high volume of trades, this means you can rack up a high volume of fees. This will vary broker to broker, but it is likely to cut into your budget. 

Momentum trading is also pretty time-intensive. You need to stay on top of your positions day to day, or even hour to hour, to make sure that you are not missing your best times to buy or sell. 

Finally, momentum trading does not work equally well in all markets. Bull markets are a better space for momentum trading, when psychology plays a bigger role. In a bear market, cautious investors can lead to smaller profits for the momentum trader. 

Momentum Trading Tips 📖

If you’re ready to try your hand at momentum trading, there are a few things to keep in mind.

  • ☑️ Have clear criteria for a good security and the right time to buy.
  • ☑️ Set stop loss or other precautionary measures in case you miss a downtrend—this will keep you from losing too much on a single position.
  • ☑️ Be prepared to put the hours in to keep up with your positions, which require closer monitoring for momentum trading. 
  • ☑️ Set trade alerts that can notify you if a stock passes a certain benchmark, so you know whether to buy or sell.

If you are new to momentum trading, you can always set up a demo account. This will allow you to practice this strategy with fake money, and see how your bets turn out. Once you’ve got it down, you’re ready to move on to trading with real funds. 

Conclusion 💬

Well, you must have had a lot of momentum to get to the end of this article! And we think we deserve a prize for making it all the way to the conclusion without an awful dad joke. (We hope.) 

Momentum trading is great for investors who want to focus on short-term trades and ride the waves of human-nature-driven trends rather than picking companies they think will rise. If you’re ready to manage your positions and get comfortable with technical indicators, you just might be able to make a pretty penny chasing trends. 

Momentum Trading: FAQs

  • What Time Frame is Ideal for Momentum Trading?

    Some momentum traders will ride longer-term trends (6-12 months), while others will use momentum trading as a day trading strategy and close out any positions before the market closes. 

  • Why is Momentum Important in Trading?

    Momentum can indicate that a trend is likely to continue in the direction it is already heading. Investing in a security with upward momentum assumes this to be true, and the trader tries to buy high and sell even higher. 

  • Is Momentum Investing a Viable Strategy?

    Many traders have had success in long-term momentum investing, and using it as a day trading strategy. 

  • How Do You Track Momentum?

    You can use indicators to track momentum such as the moving average convergence divergence and the relative strength index. 

Get Started with a Stock Broker

Fees
Account minimum

$500

$0

Minimum initial deposit

$0

$0

Commissions

$0

Vary

General
Best for

Beginners and mutual fund investors

Active traders

Highlight

Low fees

Huge discounts for high-volume trading

Promotion
Rating
Fees
Account minimum

$0

$0

Minimum initial deposit

$0

TS Select: $2,000

TS GO: $0

Commissions

Vary

$0

General
Best for

Active traders

Active options and penny stock trading

Highlight

Huge discounts for high-volume trading

Powerful tools for professionals

Promotion
Rating
Fees

Account minimum

$500

$0

$0

Minimum initial deposit

$0

$0

TS Select: $2,000

TS GO: $0

Commissions

$0

Vary

$0

General

Best for

Beginners and mutual fund investors

Active traders

Active options and penny stock trading

Highlight

Low fees

Huge discounts for high-volume trading

Powerful tools for professionals

Promotion

All reviews, research, news and assessments of any kind on The Tokenist are compiled using a strict editorial review process by our editorial team. Neither our writers nor our editors receive direct compensation of any kind to publish information on tokenist.com. Our company, Tokenist Media LLC, is community supported and may receive a small commission when you purchase products or services through links on our website. Click here for a full list of our partners and an in-depth explanation on how we get paid.

Cookies & Privacy

The Tokenist uses cookies to provide you with a great experience and enables you to enjoy all the functionality of the site.