This style of trading often carries the greatest risk, but also the best reward, and for those who like "living on the edge," it's the only way to trade, writes Jason Van Bergen.
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.
Here we take a look at momentum trading, and examine a typical day in the life of this type of active trader. Before we focus on momentum trading, let's review all the major styles of equity trading:
- Scalping: The scalper is an individual who makes dozens or hundreds of trades per day, trying to "scalp" a small profit from each trade by exploiting the bid-ask spread.
- Momentum Trading: Momentum traders look to find stocks that are moving significantly in one direction on high volume and try to jump on board to ride the momentum train to a desired profit.
- Technical Trading: Technical traders are obsessed with charts and graphs, watching lines on stock or index graphs for signs of convergence or divergence that might indicate buy or sell signals.
- Fundamental Trading: Fundamentalists trade companies based on fundamental analysis, which examines things like corporate events such as actual or anticipated earnings reports, stock splits, reorganizations or acquisitions.
- Swing Trading: Swing traders are really fundamental traders who hold their positions longer than a single day. Most fundamentalists are actually swing traders since changes in corporate fundamentals generally require several days or even weeks to produce a price movement sufficient enough for the trader to claim a reasonable profit.
Novice traders might experiment with each of these techniques, but they should ultimately settle on a single niche, matching their investing knowledge and experience with a style to which they feel they can devote further research, education, and practice.
Entire textbooks are devoted to each style, although many titles such as "Day Trade Online" or "How to Get Started in Electronic Day Trading" are unclear about what type of trading they espouse.
Let's begin our exploration of momentum trading.
A Day in the Life of the Momentum Trader
A good way to illustrate momentum trading is to look at a typical day of a momentum trader. He or she 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 or message boards.
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 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 his 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.
Up Next: Analyzing the Charts...