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introduction to momentum trading

introduction to momentum trading

On paper,momentum investingseems less like an investing strategy and more like a knee-jerk reaction to market information. The idea of selling losers and buying winners is seductive, but it flies in the face of the tried and true Wall Street adage, "buy low, sell high."

Though not the first momentum investor, Richard Driehaus took the practice and made it into the strategy he used to run his funds. His philosophy was that more money could be made by "buying high and selling higher" than by buying underpriced stocks and waiting for the market to re-evaluate them.

Driehaus believed in selling the losers and letting the winners ride while re-investing the money from the losers in other stocks that were beginning to boil. Many of the techniques he used became the basics of what is now called momentum investing.

Momentum investing seeks to take advantage of marketvolatilityby taking short-term positions in stocks going up and selling them as soon as they show signs of going down. The investor then moves thecapitalto new positions. In this case, the market volatility is like waves in the ocean, and a momentum investor is sailing up the crest of one, only to jump to the next wave before the first wave crashes down again.

Trading momentum markets require sophisticatedrisk managementrules to addressvolatility, overcrowding, and hidden traps that reduce profits. Market players routinely ignore these rules, blinded by an overwhelming fear theyll miss the rally orselloffwhile everyone else books windfall profits. The rules can be broken downinto five elements:

To increase the likelihood of choosing an investment that is liquid and volatile, pick individual securities, rather than mutual funds or ETFs, and make sure they have an average trading volume of at least 5 million shares per day.

Chooseliquid securitieswhen engaging in momentum strategies. Stay away fromleveragedorinverse ETFsbecause their price swings dont 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 with individual securities.

Seek out securities that trade more than5 million shares per day whenever possible. Many popular stocks meet these criteria, but evenlow floatissues can turn into highly liquid instruments when news flow and intenseemotional reactions draw in market players from diverse sources.

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.Biotechsand small to midsizetechnology companies create a generous supply of thesestory stocks.

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 that shake out weak hands. The hot money population finally hits an extreme, triggering volatilewhipsawsand majorreversals.

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.

Position management takes time to master because these securities often carry wide bid/ask spreads. Wide spreads require larger movement in your favor to reach profitability while also grinding through wide intraday ranges that expose stopseven thoughtechnicalsremain intact.

Choose yourholding periodwisely because risk increases the longer you stay positioned.Day tradingworks well with momentum strategies, but it forces players to take larger positions to compensate for the greater profit potential ofmulti-dayholds. 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 anoverextendedtechnical state. This overextended state is often identified by a series of vertical bars on the 60-minute chart. Alternately, the price could pierce the third or fourthstandard deviationof a top or bottom 20-day Bollinger Band.

There are lucrative profits to be made from momentum investing. For example, say you buy a stock that grows from $50 to $75 based upon an overly positive analyst report. You then sell at a profit of 50% before the stock price corrects itself. You've made a 50% return over the course of a few weeks or months (not an annualized return). Over time, theprofitpotential increase using momentum investing can be staggeringly large.

The key to momentum investing is being able to capitalize onvolatilemarket trends. Momentum investors look for stocks to invest in that are on their way up and then sell them before the prices start to go back down. For such investors, being ahead of the pack is a way to maximize return on investment (ROI).

According toBen Carlsonof the blog A Wealth of Common Sense,the entire idea of momentum investing is built around chasing performance. However, momentum investors do this in a systematic way that includes a specific buying point and selling point. Rather than be controlled by emotional responses to stock prices like many investors are, momentum investors seek to take advantage of the changes in stock prices caused by emotional investors.

However, for every silver-lined cloud, there may also be rain. Momentum investing also has several downsides. The same risk-return tradeoff that exists with other investing strategies also plays a hand in momentum investing.

Like a boat trying to sail on the crests of waves, a momentum investor is always at risk of timing a buy incorrectly and ending up underwater. Most momentum investors accept this risk as payment for the possibility of higher returns.

High stockturnovercan be expensive in terms of fees. Even though low-cost brokers are slowly putting an end to the problem of high fees, this is still a major concern for most rookie momentum traders.

Momentum investors have to monitor market details daily, if not hourly. Because they are dealing with stocks that will crest and go down again, they need to jump in early and get out fast. This means watching all the updates to see if there is any negative news that will spook investors.

Momentum investing works best in abull marketbecause investors tend to herd a lot more. In abear market, the margin for profit on momentum investing shrinks in accordance with increased investor caution.

Momentum investing can work, but it may not be practical for all investors. As an individual investor,practicing momentum investing will most likely lead to overall portfolio losses. When you purchase a rising stockor sell a falling stock, you will be reacting to older news than the professionals at the head of the momentum investing funds.

They will get out and leave you and other unlucky folks holding the bag. If you do manage to time it right, you will still have to be more conscious of the fees from turnover and how much they will eat up your returns.

Momentum trading is not for everyone, but it can often lead to impressive returns if handled properly. It takes severe discipline to trade in this type of style because trades must be closed at the first sign of weakness and the funds must be immediately placed into a different trade that is exhibiting strength.

Factors, such as commissions, have made this type of trading impractical for many traders, but this story is slowly changing as low-cost brokers take on a more influential role in the trading careers of short-term active traders. Buying high and selling higher is momentum traders' enviable goal, but this goal does not come without its fair share of challenges.

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