Momentum trading is a type of short-term, high-risk trading strategy that requires a lot of skill and practice. While momentum trades can be held for longer periods when trends continue, the term generally refers to trades that are held for a day or several days, on average.
Momentum traders strive to chase the market by identifying the trend in price action of a specific security and extract profit by predicting its near-term future movement.
Looking for a good entry point when prices fall and then determining a profitable exit point when prices become overbought is the method to momentum trading madness. Momentum trading can also involve using various short strategies to profit from market downturns.
In a sense, this kind of trading is that simple. But of course, things can be much more difficult in practice. If it were easy, then everyone would do it.
The fact of the matter is this—the vast majority of individuals who attempt short-term trading strategies like this are not successful.
History of Momentum Trading
Momentum trading is a relatively new phenomenon. This kind of trading style has been made much more readily accessible with modern technology that makes trading easier in general.
An investor named Richard Driehaus has sometimes been referred to as “the father of momentum trading.” His strategy was at odds with the old stock market mantra of “buy low, sell high.”
Driehaus theorized that more money could be made by buying high and then selling at even higher prices. This idea aligns with the overarching theme of following a trend.
During the late 2000s as computers got faster, many different varieties of this type of trading began to spring up. Some of them were driven by computer models, sometimes trading on very small timeframes.
High-frequency trading algorithms, for example, can execute hundreds of trades per second. With this type of trading, humans don’t actually do anything beyond managing the system. It’s believed that about 90% of all trades that occur on Wall Street today are executed by high-frequency trading bots.
Momentum trading has become more popular in recent years with the advent of online and mobile brokerages. There have also been a number of new investment vehicles created that are well-suited to this style of trading, such as certain exchange-traded funds (ETFs).
Ever since the widespread elimination of many commission fees back in Q4 2019, it’s possible that even more retail investors might be inclined to try their hand at momentum trading. Transaction costs and brokerage fees were also a very big disadvantage for short-term traders, as the fees could reduce profits by a wide margin.
Why are some people interested in this kind of trading? The answer is simple.
While the risks are high, so are the potential rewards.
How Momentum Trading Works
In essence, momentum trading involves picking a security (such as a stock or ETF), identifying a trend, and then executing a plan to capitalize on the trend based on the assumption that it will continue in the near-term.
There are many things that can be taken into consideration to this end. Among these are factors like volatility, volume, time, and technical indicators.
Volatility refers to the size and frequency of price changes in a particular asset. Short-term traders tend to like volatility because wild market swings can create opportunities for large profits in short amounts of time. Of course, volatility also increases risk. In fact, one of the biggest indications that an asset has high risk is often that it has high volatility.
Recommended: Understanding Stock Volatility
Volume represents the quantity of units of a particular asset being sold and bought during a certain period (e.g., the number of shares of a stock or ETF). Traders need assets with adequate volume to keep their trades profitable. Without enough volume, traders can fall victim to something known as slippage.
Slippage occurs when there aren’t enough shares being sold at a trader’s price point to fulfill the order all at once. A trade then winds up being executed across multiple orders, each of them being slightly lower than the last, resulting in a smaller profit overall. When volume is high enough, this won’t happen, as most orders can be filled all at once at a single price point.
Having a plan is part of what separates successful traders from unsuccessful ones. As discussed, momentum trading usually takes place on a short time-frame, although not always as short as some day trading strategies. While day traders might hold a position for hours or even minutes, momentum traders might hold positions for a day, several days, or longer.
Technical analysis is the art of trying to predict future price movements by analyzing charts. Charting software provides traders with a long list of tools that use different mathematical formulas to indicate how the price of an asset has performed in a specific timeframe. These tools are referred to as technical indicators.
Based on one or more of these indicators, traders try to infer what the near future holds for a security. This process is far from perfect, and technical analysis might best be described as only slightly predictive. Still, it’s an important part of a short-term trader’s arsenal. What do these indicators look like?
One of the simplest technical indicators is called the Relative Strength Index (RSI). This indicator is supposed to chart the recent strength of a stock based on closing prices during a given period.
The RSI provides a simple numerical value on a scale from 0–100. The higher the value, the more overbought a security might be, while a lower value indicates a security might be oversold. In other words, a low RSI can be a buy signal, while a high RSI can be a sell signal.
The topic of technical analysis goes far beyond the scope of what can be covered here in this article. For a more detailed look at the subject, take a look at this SoFi resource.
Advantages of Momentum Trading
The main advantage of momentum trading is that it can be profitable in a relatively short amount of time when executed correctly and consistently.
Whereas buy-and-hold investors tend to wait months, years, or even decades before seeing significant profits, successful momentum traders have the potential to turn out profits on a weekly or daily basis.
While investing for the long-term requires a good understanding of the fundamental factors that go into each investment, momentum trading tends to be focused around technical analysis of charts.
While this method of trying to predict price movements is by no means infallible, it does keep things simple. Traders are focused through a single lens rather than trying to comprehend the bigger picture.
In this sense, momentum trading may be simpler. But compared to long-term investing, short-term trading involves a lot more buying and selling, and that creates additional opportunities to make mistakes.
Disadvantages of Momentum Trading
As mentioned, there are a lot of risks involved in momentum trading. Momentum traders try to make inferences about future price movement based on the recent actions of other market participants. This can work, but it can also be thrown off balance completely by a single press release or fundamental development.
For example, imagine a momentum trader identifies a strong upward trend in a stock of a telecommunications company we will call Company A.
This imaginary trader develops a plan and begins executing it, placing a buy order at a select price point when the stock dips. The plan is to sell once the stock reaches a long-term resistance level that was established months ago, let’s say.
Our hypothetical trader has done this same trade before many times and made a nice profit each time, so she thinks this time will be no different.
But then something unexpected happens. The next trading day, when profits were to be booked on a continued rising price trend, a rival telecommunications company, Company B, issues a press release.
Company B has pulled ahead of Company A, implementing a new technology that will benefit customers greatly. As a result, investors begin selling stock in company A, expecting them to lose customers to competitors like Company B.
In this imaginary case, any trends that might have been identified using technical analysis would have been invalidated quickly. Hypothetical scenarios like this play out every day in the real markets.
Tax Implications to Know
Those interested in momentum trading or other short-term trading strategies may want to review the tax implications associated with this style of trading. It can be worth reviewing how taxes will impact an investor, since they could take a chunk of an investor’s profits.
Know that the IRS makes a distinction between traders and investors, for tax purposes, and it’s important to understand where you fall. A trader is someone considered by law to be in the investment business while an investor is someone buying and selling securities for personal gain.
The IRS also differentiations between short-term and long-term investments when evaluating capital gains and losses. In general, long-term investments are those held for a year or more, while those held for less than a year are considered short-term investments. Long-term investments may benefit from a lower tax rate, while short-term capital gains are taxed at the same rate as ordinary income.
Another rule worth understanding is the wash sale rule . While some capital losses can be taken as a tax deduction, there are certain regulations in place to stop investors from taking advantage of this benefit. The wash sale rule restricts investors from benefiting from selling a security at a loss and then buying a substantially identical security within 30 days. A wash sale occurs if you sell a security and then your spouse or a corporation under our control buys a similar security within the 30 day period following the sale.
Investing With SoFi
Now you have some answers to the question, “what is momentum trading?”
In short, it involves a combination of techniques that attempt to predict and take advantage of short-term market fluctuations. This skill is hard to master, requires a lot of knowledge and experience, and carries high risk. This kind of trading is not for everyone.
No matter what kind of trading you’re into, the SoFi Invest® provides all the tools needed to get started.
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