An Introduction to Momentum Trading

At first glance, momentum trading looks a lot like a poor investment decision. Most investments follow the basic concept of “buy low, sell high.” Momentum trading, on the other hand, is more about “buying high and selling higher.” While it may seem greatly appealing to sell off your losers and try to ride the winners, it’s a system which operates on a risk-reward system that seems tricky to break into, let alone master. If you’re looking for a new investment strategy to incorporate into your portfolio, here are a few basics on momentum trading.

Foundations of momentum trading

“The trend is your friend.” If you’ve heard this phrase before, it was likely in regards to some form of momentum trading. The thought behind momentum trading is that once a trend begins to move in a given direction, it’s likely to keep progressing in that direction for the time being. Your goal as a momentum trader is to catch the middle of this trend when the momentum begins to accelerate and sell off when it slows or when you’ve hit a desirable profit margin. While this type of trading can be done long-term, it is most often done short-term.

It seems like a simple concept, right? Hop on a train as it begins to speed up, hop off when it starts to slow down or you’ve reached your destination. The momentum strategy takes full advantage of the market’s anomalous tendency for rising prices to keep rising and falling ones to keep falling. Since it’s not easily explained by any existing financial theories, momentum trading was often ignored by advisors and industry experts. However, it’s proven to work and is often a great beginner’s trade as it’s easy for new traders to follow trending alerts and take advantage.

Best markets for momentum trading

When it comes to which markets you should start with, there are some differing opinions. Some advisers swear by liquid securities while others believe regular funds are the way to go. A few markets that are optimal for momentum trading with a lower barrier to entry are growth stocks, indices with a high trade volume, and cyclical assets.

Growth stocks refer to stocks that typically rise and fall by over 50 percent in a year. These are most frequently consumer and tech stocks and if they have a high growth rate and are heavily traded, they are frequently referred to as momentum stocks.

Indices with a high trade volume refer to major stocks like NASDAQ and S&P 500. For day traders, this market is ideal because it sees a lot of movement in a short timeframe. When it comes to momentum trading for these stocks, pursuing futures and exchange-traded funds (ETFs) is a good strategy but it’s best to avoid inverse ETFs, as their fund construction tends to be complex and their price swings make it difficult to track future markets.

Cyclical assets are a solid starting option if the trading range potential is wide enough. These include cyclical commodities and stocks and are so named because they’re directly impacted by the economy.

Getting started

As with any initiation into a trading strategy, it’s best to start off small and low-risk while you work out the finer details of your trades. Momentum trading is no different. Ultimately, when selecting a market and strategy, you need to assess your comfort level before deciding which trends to pursue. If you’re unsure of how to proceed, there are plenty of online resources and contacting a financial advisor can prove advantageous. Momentum trading takes a keen eye and an ability to strike while the iron is hot, but the higher risk often leads to greater rewards. Choose wisely and get trading!