In momentum trading, traders focus on stocks that are moving significantly in one direction on high volume. Momentum traders may hold their positions for a few minutes, a couple of hours, or even the entire length of the trading day, depending on how quickly the stock moves and when it changes direction.
A Day in the Life of the Momentum Trader
Let me illustrate momentum trading by leading you through a typical day of a momentum trader:
He gets up an hour before the market opens, switches on his computer, goes online, and immediately logs into one of the popular trading chat rooms. The site to which he surfs is probably one of Ken Wolff's Momentum Trader (www.mtrader.com) or Day Traders On-Line (www.daytraders.com).
When looking at these boards, our hero focuses on stocks that are generating a significant amount of buzz. He looks at stocks that are the focus of trading alerts based on earnings or analyst recommendations. These are stocks that are rumored to be “in play” and are anticipated to provide the most significant price movements on high volume for that trading day.
While surfing the Wild Web, he will also turn on CNBC and listen for mentions of companies that are releasing news or are positioned to undergo significant movement.
He puts an eye to the morning equity options pages, where he looks for stocks with significant increases of volume in calls. Any increase in calls written is an important indication that a price increase or decrease above or below the option premium is expected to occur.
Once the market opens, he watches his initial list of stocks in relation to the rest of the market: are his stocks going up when the market goes down? Are they significantly increasing in price in relation to the rest of the market? Are they behaving consistently with the expectations based on his pre-market assessment?
He will then narrow his “watch list” to include only the strongest stocks: the stocks that are increasing more rapidly on higher volume than the rest of the market, the stocks that are trading contrary to the market, and the stocks whose movements are clearly being propelled by external factors.
Once these key stocks are identified, he will analyze them further by examining their charts. The primary technical indicator of interest is the momentum indicator, the accumulated net change of a stock's closing/ending price over a series of defined time periods. The momentum line is plotted as a tandem line to the price chart, and it displays an axis of zero, with positive values indicating a sustained upward movement and negative values indicating a potentially sustained downward movement.
That upward or downward momentum indicator often immediately portrays a “breakout” for the stock, which means that even a period or two of sustained momentum will propel that stock in the direction of the breakout. At the same time as watching the momentum chart, he also has his Level II screen up, looking for evidence of a “push," where bids start to line up (indicated by the presence of market-maker limit orders) and offers start to disappear.
When the trader believes he has identified a breakout, he does not necessarily need to jump immediately into the stock. He is not generally worried about missing the first one or two breakout ticks, but he has his hand on the buy trigger (or sell trigger in the case of a short sale, but a short sale must be done on an up tick) for one of the next momentum periods. And he is generally not too concerned about hitting the bid either, as he will have an easier time getting in at the market price. Then he places a market order.
Once he has entered into his position, the white-knuckle ride and nail-biting begins. Will the stock continue to move strongly in the direction of his momentum line? Or will it immediately change course, proving the momentum chart wrong and perhaps pointing to a trap set by the market maker? Or will the breakout fizzle quickly, providing some limited upside but not sufficient profit to make the trade worthwhile?
Whether the momentum fizzles almost immediately or continues to build, the trader remains glued to his screen. He is looking for a “saturation” point, where orders start piling up on the offer and bidding slows or thins at the market price a few levels back on the Level II screen. The saturation point does not mean the immediate end to the momentum, but it may be a sign that the top is near. So the trader sells his position (or covers his position in the case of a short sale) and takes his profits to pack it in for the day or to move on to the next stock on his list.
It should be noted that in the event of a breakout gone wrong, where a stock immediately turns direction and moves against the trader's wishes, a special strategy applies. Far from hoping for yet another reversal to make the stock go his way, this astute trader immediately cuts his losses and sells (or covers) his position. It is often a far better strategy to take a small loss early after a bad trade than to hope for a reversal later in the day. The odds generally ensure that a small loss will turn much larger the longer the trader waits with crossed fingers.
And here's where psychology rules the roost: the astute trader realizes that there WILL be bad trades that result in losses. By accepting that fundamental fact of trading life, he or she will minimize his or her so that trades that go swimmingly will outweigh these losses.
By way of summary, the pitfalls of momentum trading are follows:
Because of these pitfalls, momentum trading is fraught with peril that can easily destroy even the most disciplined and knowledgeable trader; however, this style also offers the most potential for significant profit since there is rarely any factor inside or outside the market that drives a stock as powerfully as momentum. With a proper understanding of the technique, sufficient knowledge of the risks, and willingness to take an occasional loss, momentum trading offers an appealing choice for the aspiring trader who enjoys living on the edge.