I have a friend who is a travel agent. He lives in Delhi and like a lot of Delhiites, he loves the weather in his city between December and February but hates the unbearably hot weather that the city faces in May. He plans all his international business trips one after the other around April and May when the temperature is too high and spends the maximum time in the city during the cooler months. He is in the city during the cooler months and out when temperatures hit their peak. Momentum trading follows a similar strategy, but instead of tracking temperatures of course, traders track stock prices. Momentum traders will buy a stock when it's price is at a low and sell the stock when its price touches its peak.
Momentum traders are on the lookout for short term upswings in stock prices. They want stocks that display tremendous volatility because that's how they have the potential to earn at quicker intervals.
Traders that use momentum trading strategies, move in the opposite direction of the herd. More specifically, when everyone is selling a stock, momentum traders will buy it instead. This is because aggressive selling of shares or dumping of stock pushes down its price, giving the momentum trader a suitable buying opportunity. When momentum traders start buying stocks, demand gives stock prices the momentum to move upwards.
On the risk scale, momentum trading is perched fairly high up, given that it thrives on extreme volatility. As a result, momentum traders routinely follow a handful of basic rules that can help them navigate the high-risk environment that they choose to operate in.
The moral of buy low - sell high sounds about right, but applying that strategy to just about any stock whose price is going downhill is clearly a foolhardy way to go. Momentum traders have a set of selection criteria in mind.
For example, they will usually go with liquid stocks. The common consensus is that liquid stock price swings do a better job with tracking fundamental indices and futures markets.
Momentum traders truly have a finger on the market's pulse. They are often experienced, with a trained eye for opportunity. When new product launches, mergers & acquisitions or some other exciting new concepts (or gimmicks) with the ability to create ripples in the market appear, momentum traders step in to create momentum for a stock price upswing.
Momentum traders are also usually on the lookout for high volume. Remember that volume affects liquidity and therefore it is imperative that one look for high volume stocks to trade using the momentum trading strategy. Of course, some momentum traders have success stories emerging from low volume sticks that created ripples allowing the momentum trader to ride the price wave and exit. However that type of strategy further escalates the risk involved in the already high-risk strategy.
Momentum traders enter early in the game. When some shocking news hits a stock price, momentum traders will buy in when everyone is selling. Or if a brand new product or concept (like video conferencing apps in Feb or March this year for instance)... when a new concept like that hits the stands, momentum traders will be the first to buy in while the rest of the world is waiting and watching.
While in the game
Day trading is usually preferable for momentum traders. Anything can happen after the close of the trading day. The next morning could depict a completely different (and potentially far less profitable) picture of a stock price. Momentum traders need to keep a constant check on their stock prices so as to not miss an opportunity. The optimum situation that momentum traders seek out is a short holding period with smaller position sizes over multiple sessions. Traders may be tempted to take larger positions so as to enjoy a bigger multiplier effect of profits, but a close look at popular strategies used in momentum trading will reveal that they prefer to have a smaller position size and instead partake in a number of trades instead so as to reduce risk.
Using the 20-day Bollinger Band as a momentum indicator, momentum traders exit when they see the stock price hit a previous high. They view this as the stock price having hit its peak, which according to their "buy low sell high" strategy, is their exit cue. Another momentum indicator that may be employed in momentum trading is RSI, that is relative strength index.
Momentum trading as a stock trader's strategy offers the potential of higher earnings over a short period. However, it is also high risk which means potentially high losses, in the event that a prediction goes wrong. It is also very time consuming because the trader needs to have his eyes glued to stock prices at all times to avoid missing an opportunity. Traders must also consider the cost of trading (considering the fact that momentum trading involves many little trades and each one attracts a fee to be paid to the broker) while calculating whether they have actually made any earnings.
If you are an amateur trader or a trader with a small amount of experience, momentum trading could be a goal that you work towards. Over time, you work on developing an eye that can spot quick uptrends. For beginners and even for experienced traders with a cautious attitude or a low risk appetite, momentum trading may not be the answer although it holds the glimmer of potential earnings. Always consider your risk appetite before investing in the stock market and be sure to only trade with capital that remains in hand after basic living expenses are taken care of.