Investing 101: How Does Momentum Trading Work

Stay-at-home orders, market volatility, social networking, and no-fee brokers all served as catalysts to introduce lots of people to the stock market over the past several months. New trading apps also made it easy for tens of millions of new investors to enroll with a broker and start trading right away.

For many people, the stock market provided a novel activity that could help them grow their savings — from the comfort of their homes. Some even turned trading into a vocation to replace some or all of their lost income. Either way, making profitable stock market trades can offer plenty of benefits to anybody who wants to earn income from their savings.

Of course, not every trade turns a profit. That’s particularly true for inexperienced investors who skip doing their research and analysis in favor of buzz generated on social media platforms. Read on to learn more about an investment approach known as momentum trading.

Momentum Trading Defined

Momentum trading refers to a short-term strategy of buying stocks while prices rise and then selling them before they’ve peaked. That means savvy investors can take advantage of the volatility generated by company news, changing market conditions, or even social media hype. However, successful momentum traders still need effective tactics to pick the right tickers and know when to enter and exit the market.

Here are common qualifiers of any successful momentum trading strategy:

  • Choose stocks with momentum: As the name of the strategy suggests, traders need to find stocks with enough market action to support spiking prices. In general, momentum traders may browse stock forums and social sites or read market news to find potential tickers. Of course, traders can also use stock listings and special tools to find trading volume and price information.
  • Control for risks: Everybody wants to buy low, but it’s risky to enter a market before the price trend has confirmed positive momentum. After opening a position, a trader also needs to keep a careful watch on the price to look for signs of a potential reversal or change in sentiment.

The Importance of Timing Trade Exits

Just as these volatile stocks can peak rapidly, they can sometimes also fall just as fast. Taking profits must triumph over the urge to try to increase profits just a bit more. In any case, timing exits appear to offer an even greater challenge than entering at the right time.

Since stocks often become volatile because of investing sentiment and emotion, it’s important for momentum traders to understand this and put their feelings about the company to the side. In particular, it helps to understand technical analysis enough to select specific indicators on a chart. These indicators can help traders make objective decisions by alerting them to the potential for changes in price direction.

For a couple examples of trading indicators to research:

  • Momentum indicators: Momentum indicators demonstrate the relative direction and strength of price movements. As an example, they can show when price increases have started to slow, meaning that the stock may have begun to lose momentum.
  • Oversold indicators: Technical traders commonly use the relative strength index (RSI) to spot potentially overbought trends that usually predict corrections. In general, an RSI over 80 signals overbought stocks.

How to Prosper With Momentum Trading

While emotions may fuel buying activity and price spikes, successful traders should rely upon a sensible strategy and data-driven insights.

Just as with advanced tech to enable buying and selling stocks, traders can now take advantage of advanced portfolio trading tools to display charts and helpful price indicators. As an example, investment insights provide customizable price charts and plenty of other portfolio statistics.

Ultimately, good traders need a strategy to spot likely winners and manage risks. While momentum trading isn’t the right tactic for everybody or even every trade, it’s gaining a lot of attention in this era of stock market hype and volatile prices.