Chapter 18
Short-Term Trading Strategies, Part 2: Momentum Trading
In This Chapter
• How momentum traders make money
• Finding entry points
• Moving with the market and news
• When to exit—the key to success
Momentum traders might be called the surfers of short-term trading—they ride the wave price movements, then bail out just before the wave crashes on the beach. Okay, the surfer metaphor is a stretch, but momentum traders do share something important with surfers: they stay with the stock until it begins to lose its momentum before exiting.

How Momentum Trading Works

The key for momentum traders is identifying a stock that is rising (or falling) on strong volume and then getting in early. But that’s only part of the success formula. The momentum trader must know when to exit to avoid losing any profits. This is definitely not a contrarian strategy because traders are relying on the flow of the market to provide the energy for pushing prices in the direction they want. While scalpers may shoot for many small profits, momentum traders look for fewer but larger profits. It’s a risky but rewarding, strategy if done correctly.
Trading Tip
Momentum trading is higher on the risk scale than many other forms of trading because you wait for an uptrend to end before exiting. The trend may last only a few minutes or it could stretch out for hours.

Keeping an Eye on Volume

Momentum traders look for stocks making a strong move on high volume. The price increase or decrease would be above the normal daily trading range and would exhibit signs of sustainable strength. Traders would confirm the move using technical and fundamental tools we’ll discuss below and take the appropriate position. Traders know that once a price trend is in motion it will continue until it encounters something to stop or reverse it. Traders will stay focused on the activity around the stock, watching for signs that the momentum is slowing. When they spot the warning signs of slowing momentum, traders exit the position.
While this sounds easy, it requires a careful set-up, patience, and extreme discipline to be successful. In many ways, it is riskier than scalping because momentum traders make fewer trades with higher potentials for reward and loss. A scalper may be happy with a trade that yields a $0.25 per share profit, but many momentum traders shoot for trades that make in excess of $1 per share profit. With the potential for larger profits comes the possibility of large losses.

Finding Stocks for Momentum Trading

The momentum trader’s big task is finding the right stock to trade. Each day, that may be a different stock, depending on what is happening in the market and to the company. News developments such as quarterly earnings reports or announcements from the company can produce dramatic price changes. Action for or against the company by a government regulatory agency can also have a serious effect on stock prices. Many of these events intentionally happen after the market closes so their impact on prices is not reflected until the next day’s opening. The stock may gap up or down depending on the announcement. We’ll discuss gaps later in this chapter.
Volume is a critical piece of the selection equation, as we have noted in other areas of the book. Volume is a confirmation of the strength or weakness of a trend. Momentum traders will avoid stocks that show big price changes on weak volume because it is unlikely that the trend will hold.
Momentum traders begin their search before the market opens by looking at news wires and consulting various news groups they trust to see if any stocks or industry sectors are getting a lot of attention. This begins the narrowing-down process that will help the trader eventually focus in on a short list to trade. While it is easier to follow an upward trend, momentum traders can work the short-sell side of trading, too, by looking for stocks that are breaking down and not up. In some markets, you will find more “new lows” and “new highs.”
Momentum traders aren’t afraid of stocks trading at or near record highs (or lows). After all, the whole premise of momentum trading is that prices will continue in the same direction until there is a reason for a reversal. Traditional investors are told that the road to riches is to buy low and sell high—a formula that works and has made investors such as Warren Buffett extremely wealthy. The problem occurs when you buy low and the stock stays low or goes lower. Momentum traders, like all traders, are impatient and will not wait for an investment to mature to profit. They are willing to buy an overbought stock if they believe it will rise higher still because they plan to sell as soon as there is any whiff of slowing momentum.
Market Place
Momentum trading on price increases works best in a bull or flat market. Traders can use the same strategy and short (sell) stocks on downward trends, although many find it easier to look for rising price candidates.

The Breakout

Traders call a strong departure from a previous trend a breakout. The problem for momentum traders is knowing what a true breakout is and what is just an excited blip that’s going to fizzle in a matter of minutes or seconds. There is no absolute indicator that will guarantee a breakout is for real. Momentum traders can use several indicators to confirm as best they can that a breakout is going to have some sustainability. None of these is foolproof, which is why we’ll discuss emergency exit strategies below in detail.
Breakouts are strong divergences for existing price trends. They signal a new and powerful direction for the stock. The direction may be bullish or bearish and will continue until it runs out of energy.
This is one of the major risks of momentum trading—misidentifying a trend and taking a position only to have it reverse on you almost immediately. There are protective measures you can take to minimize your losses, but you’ll take a loss just the same. The loss may be small (if you’re disciplined it will be); however, small losses add up over time and become a drain on your investment capital. In addition, the time you spend on losing trades is time you are not spending on winning trades, so you have a lost opportunity cost in addition to the actual monetary loss. Paper trading for an extended period will help you hone your skills before risking real money.

The Momentum Indicator

Momentum traders use the momentum indicator to confirm a breakout. This calculation offers insight to the trader if the price trend will continue or is about to break. It is plotted on a chart with a moving average to spot movements up or down. The momentum indicator is a simple mathematical calculation in which the closing price of X periods in the past is subtracted from the most recent closing price. If the answer is positive, then momentum is positive. Conversely, if the answer is negative (meaning the most recent closing price was lower than the price of X periods in the past), then momentum is negative.

The Rate of Change

Traders can also use the same two numbers to calculate the rate of change. Take the most recent closing price and divide it by the closing price of X periods in the past. If the most recent closing price is higher, the answer will be greater than one. The higher the positive number, the faster the rate of change.
The period in the past should not be too far back since you are interested in what’s happening now.
There are actually many momentum indicators in technical analysis. You will find resources in Appendix A to help you learn more about technical analysis and leading and lagging indicators.

How Long Do Breakouts Last?

The most difficult question facing momentum traders is how long a breakout or upward trend will last before running out of energy and reversing itself. Some breakouts will collapse almost immediately as sellers take quick profits and drive the price down. Other breakouts will last for minutes or hours. Going into the trade, there is no way of knowing for sure how long it will last. Traders can use some technical indicators that may give you an idea to the strength of the breakout, but a reversal could come at any time.
Momentum traders make it a rule to not worry about getting in on the absolute ground floor or be concerned about holding out for the last nickel of profit before selling. If you jump in immediately on the first signs of a breakout, you will probably lose more money over time than you will gain. Smart momentum traders are not concerned about the first few price jumps, because they may confirm or deny the trend. Likewise, traders would rather exit early than wait too long and have the market turn on them.
Margin Call
Technical indicators, including momentum indicators, are not perfect. You may see a nice pattern on your chart for a breakout toward rising prices only to have prices move in the opposite direction on some bit of news no chart could anticipate.

Keeping Watch

Momentum traders can’t afford to be away from the market for long if they hope to retain their profits or keep losses to a minimum. Once they have done their preliminary research and scoured the news sites for potential investing opportunities, momentum traders finally pull the trigger and buy (or sell). Now comes the time for vigilance. Breakouts, despite what charts or indicators may tell you, can collapse in the blink of an eye. Traders can protect themselves by keeping focused on their charts, but also on their Level II screens, to note when volume on the ask side starts growing.
The trader has no way of knowing whether the breakout will last three minutes, three hours, or three days (or three seconds, for that matter). Material about technical indicators may give you the impression that these signs are as clear as traffic signals. However, that’s simply not correct. If they were always correct, traders would never have losing trades. The best you can hope for is guidance—a suggestion about a general direction. This is certainly better than no help at all, but don’t read technical indicators or technical analysis as if it were incontrovertible fact.
It is critical that the trader watch for signs that momentum is about to slow, and the sure sign of that is a building list of sell orders on the Level II screen. This will usually correspond with a diminishing number of buy orders, indicating that traders are ready to take profits.
Trading Tip
Advanced trading platforms offer several tools to traders, including alerts when prices of selected stocks move in a particular direction by so much. This automatic monitoring system is a great help, but nothing replaces your attention to the market.

Momentum and Gaps

Gapping stocks present a number of possibilities for short-term traders as we have seen with scalpers who look for them as opportunities. Stocks that gap up or down on opening may also be good candidates for momentum traders. Momentum traders need some patience with gapping stocks to see which way the stock will head after the opening bell. The momentum trader will want to know why the stock gapped at opening and if the cause is still in play. In many cases, company, market, or economic news was the driving force behind the gap. Will the momentum that built the previous day continue into today’s trading?
When a stock gaps up—that is, it opens significantly higher than its previous close—one of two things will happen. It may sustain the enthusiasm for a short while, then fall back toward the lower previous close or the momentum will continue pushing the price up. In some cases, the price may retreat briefly, then push ahead. This is a case where the momentum trader should be very sure of what is happening before entering a trade.
Entering too soon may find the trader buying into a stock that is falling back to the previous lower close.
Market Place
Many advanced trading platforms offer a stock screener that includes screens for stocks that gap up or down on opening. This is a great time-saver.
What looked like a breakout was not sustainable. Check volume in early trading for confirmation that this stock is still attractive. If volume is high, check your Level II screens to see where orders are accumulating. If sell orders are piling up, this is not a breakout that is going to last very long. If buy orders seem to be dominating and your technical indicators indicate a bullish trend, the breakout is as confirmed as it can get.
Traders may miss some of the early trading gains, but by waiting, the have reduced the risk that the breakout will blow up immediately after they enter their trade. In a volatile market, traders may find that many breakouts blow up quickly, and momentum traders can’t afford long strings of small losses.

The In-Between Approach

The stock market is a place where many strategies are employed. All of the rational strategies work some of the time, but none of the strategies work all of the time. The main reason is that the market itself is a very dynamic and robust mechanism. The market is constantly changing and responding to an economy that is also always in a state of change. Given this background, it is no surprise that trading strategies must accommodate the market because the market never changes to fit your needs.
Some investors employ a strategy that is similar to momentum trading. The biggest difference is that these investors may hold a position for a much longer period—days, weeks, or months—than a trader who always closes at the end of a trading day. Momentum investors recognize the power behind a trend and stay with their position for an extended period. You can buy momentum mutual funds that employ this strategy. However, from the trader’s perspective, the idea of holding on for extended periods has two problems. First, it is more difficult to find stocks that will sustain a trend for a lengthy period. Second, the longer you hold a position, the greater the chances are that something bad will happen to your profits.
Undoubtedly, there are traders who argue for an in-between position—not letting profits run as long as they want, but also not closing a good trade just because the market is closing. This is an individual decision each trader must make. There are compelling arguments for holding a good (profitable) trade overnight. However, many short-term traders will testify to all the bad things that can happen during that period between market close and open, when you have no way to protect yourself.

Which Way Is the Exit? Exit Strategies

Successful momentum traders know as much about quitting a trade as they do about entering one. Both steps are equally important to securing a profit or cutting losses. We noted earlier that momentum traders don’t necessarily jump on the first hint of a breakout. They may wait to see the price moving up to confirm the breakout before entering the trade.
In the same manner, momentum traders do not wait until the breakout collapses to exit their positions. Smart momentum traders know that it is better to leave the trade early while a profit is assured than to hold on for a few extra pennies. As traders watch their charts and Level II screens, they decide when momentum is beginning to slow and sellers are beginning to line up preparing to take their profits. Momentum traders know that when the price hits those limit orders, everyone will start selling and the price will drop quickly. They exit their positions before the crowd heads for the exit.
This may mean they could have made more money by staying with the position a while longer, but smart traders take a sure profit and don’t worry over more profit that they might have made.
Margin Call
It is dangerous to attempt to time the end of a trend. If you are caught when the sell orders begin, the price may drop so fast you will see most of your profit disappear before you can get out of your position.

Settling the Score

Fear and greed are the two most dangerous emotions for any trader. They will ultimately cloud your judgment and ruin any trading plan. Momentum traders must understand this completely and be content with taking a nice profit and not be tempted to take more. By waiting for confirmation of a breakout before entering a trade, momentum traders may lose 10 percent or more of the potential profit. Exiting the position at the first signs of weakening momentum may cost traders another 10 percent or more of the potential profit. However, for the traders’ 80 percent, they are capturing a more certain profit at a lower risk.
Even though technical analysis cannot provide perfect tools for entry and exit points, you should learn to use the momentum indicators. When coupled with a practiced observation of Level II screens, they can give you an edge that will make momentum trading less risky.
Don’t be fooled by traders who tell you they have a “feeling” about the market and can sense when to enter and exit. Either they are telling you a tall tale or they are telling themselves a tall tale. If the latter, the trader won’t be around for long. The market is too complex and driven by too many factors for an individual to sense its upcoming changes.
People may talk about the market as if it was alive, but it is not. The market is a complex economic engine that few, if any, completely understand. Don’t be fooled by people selling systems that claim to crack the “secret” of the market. There is no secret. There is no single system that will work every time, all the time. The market is constantly changing—it is different every day and by the time you figure out what is moving the market today, it changes and some other factor is more important. That is why momentum traders—and other short-term traders—are willing to take a certain profit even if it is less than was theoretically possible.

Protect Yourself at All Times

Momentum traders spot an upward movement on strong volume, confirm the trend, and take a position. Now the waiting and worrying begins. Traders are concerned that the trend will end before they can make a profit or even enough to cover their expenses. They can watch their charts and the Level II screens for any sign of slowing momentum and sell to protect any profit or reduce any loss. What if traders don’t want to sit glued to their screens, or more likely, what if they have several positions open at once? How can they protect their positions?
One way to protect your profits and limit losses is to use a technique called trailing stops. Trailing stops is a way for you to automatically protect a position that is rising. A stop is an order that only executes when a certain price is hit. In this situation, the trader wants to protect a profit, so the stop is set behind the current market price by a small margin. If the price of the stock falls to this stop, the stop order becomes a market order to sell and is immediately executed.
Market Place
Market orders don’t guarantee you will get the current market price, but they do guarantee you will go to the head of the order list for execution. This is not the most elegant way to exit, but it is fast and, if the price is falling, the safest way out.
For example, if the current market price is $35 per share and you bought the stock at $28 per share, you might set a stop at $32 per share. This would give the stock some room to fluctuate up and down without tripping the stop order. However, if the stop came under heavy selling pressure and began to fall, you would want to get out with some of your profits. When the price hits $32 per share, your stop order becomes a market order to sell and you get (hopefully) close to $32 per share.
Trailing stops take the protection one step farther and work with stocks that continue to rise. Trailing stops follow the price of the stock as it rises. They are sometimes expressed as a percentage of the market price. For example, you might set a trailing stop at 10 percent of the market price. This means no matter how high the stock rises, if it ever falls by 10 percent of its current market price, the stop is activated and becomes a market order to sell.
The advantage of trailing stops is that you don’t have to watch the stock’s price every minute the market is open. As long as the stock continues to rise or stays flat, the stop order just sits there. Only when an event triggers a reversal in the upward trend will the stops be activated. Some traders prefer alerts to using stops. Alerts are offered by a number of vendors and come to you via e-mail, text messages, and other vehicles.

The Risks of Momentum Trading

Momentum trading can be a very profitable endeavor. It works just as well on the downside as it does on the upside. However, momentum trading is also risky. There are a number of things that can and do go wrong. Most of the problems are “operator error” and can be avoided with practice, patience, and discipline. Most momentum traders fail because:
Trading Tip
Momentum trading is not a good place to start your career in active trading, but it is worth considering once you have some experience in other forms of trading.
• They miss the right entry and exit points.
• They try to extend their profits and hold a position too long.
• They refuse to close a bad position in a hurry.
• They become distracted and miss key signals from charts and Level II screens.
• They fail to close a position at the end of a trading day.
If you believe you have the patience and discipline to be a momentum trader, try your hand on paper before committing real money to the process. Appendix A has some resources for getting you started.
The Least You Need to Know
• Momentum traders look for trends on strong volume.
• Momentum traders confirm the trend before taking a position.
• Momentum traders watch the stock closely and exit when they see momentum slowing based on indicators.
• Momentum trading can be very profitable, but it carries a higher risk.
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