What Retail Traders Need to Know About Momentum Trading
2021 has been a wild year for markets. When it started, the Dow Jones Industrial Average had just crossed the 30,000 thresholds. And with the arrival of vaccines, optimism was riding high.
But things were about to get even wilder. On a Reddit message board called WallStreetBets, the fervor was rising around GME or Gamestop. In that forum, the user known as DeepF*ckingValue had built a bull case around the stock.
As it turned out, he was right. Shorts had caused the equity to be dramatically oversold – and as a result, they were vulnerable to a squeeze. Not long after that, GME exploded, hitting highs as lofty as 483.00. As of June 2021, the stock is still up 1,000% over its January 2nd close.
But GME hasn’t been the only stock to pop its top. AMC stock, another heavily shorted equity, has also attracted a ton of attention. At press time, AMC was up a whopping 2,670% YTD.
Now there are scores of other examples from this year, like BB and NOK. But as crazy as things have been recent, these financial-feeding frenzies are nothing new – it’s a phenomenon known as momentum trading. In this post, we’ll educate you on what it is, and whether this trading philosophy is worth adopting.
What is Momentum Trading?
Everybody wants to ride a rocket ship to the moon. And if you could do so reliably, why wouldn’t you? By harnessing exponential gains, you can amass wealth far quicker than by parking your cash in an ETF.
That’s the motivation behind momentum trading. You find a stock that’s already rising and you buy it. You watch its charts for signs of a peak. And when it arrives, you get out. Boom – max profit.
Of course, it’s not nearly as easy as it sounds. If it were, we’d all be millionaires. Fear and greed can lead investors to cash out well before the peak. And on the downside, the sunk-cost fallacy can cause investors to hold on far longer than they should.
We humans, who are slaves to our emotions, find it incredibly difficult to succeed at this form of trading.
Momentum Trading is Incredibly Risky
Momentum trading thrives on volatility. But volatility is a double-edged sword – what rises fast crashes to Earth just as swiftly. So if you feel compelled to try momentum trading, don’t do it with money you can’t afford to lose.
Whenever an equity or commodity spikes, the downside is littered with stories that’ll break your heart. Don’t become a statistic – leave the majority of your life savings in a stable fund. Rather than gamble with your retirement, make little bets with a portion of your disposable income.
This way, you’ll gain an education in momentum trading without losing your shirt.
Read Up on Technical Analysis
But don’t just randomly jump aboard surging stocks. Left to your own devices, you’ll struggle with your emotions as your equity’s price gyrates wildly. To avoid selling too early or too late, learn how to read a stock chart.
This art/science is known as technical analysis. At its core, technical analysis involves watching an equity’s trend lines for indications of future movements. Depending on the patterns observed, you can determine whether it’s likely a stock will continue to rise. Although these predictions aren’t always correct, they make it easier to buy, hold, or sell equities.
While you can come to these conclusions by studying candles, several tools allow you to further refine them. Of these, the moving average is among the most popular. This stat takes recent stock prices and turns them into a smooth, averaged line. If your stock is above that line, buy. When it sinks below it, sell.
The Relative Strength Index (RSI) is another well-used metric. The RSI evaluates how over/undersold a stock is on a scale of 0 to 100. According to conventional wisdom, equity that has an RSI of over 70 is due for a correction, while one under 30 is primed for a rally.
Get In, Then Get the Heck Out
But even with a solid backing in technical analysis, know that momentum trading is not a long-term pursuit. Most stock rallies/plunges are short-lived – generally speaking, the steeper one is, the sooner it’ll reverse.
So, if you’re riding the momentum of AMC, GME, or the latest meme stock, pay attention. You get in, and then you get the heck out. Don’t linger any longer than you should – when the indicators say sell, do it.
But selling can be tough if your equity is highly illiquid. This scenario presents itself when you hold a stock with a low float, such as those found in OTC markets. That doesn’t mean you shouldn’t buy microcaps and penny stocks – it just means you need to be super-alert for sell signals. Obey them, and you’ll be less likely to be left holding the bag.
Don’t Try This at Home Kids
Momentum trading is NOT for beginners. It’s a high-risk philosophy that eventually burns everyone who tries it. Because of this, you need to have a solid risk management strategy in place before adopting this approach.
Not every momentum play will go your way. And on a few, you’ll take huge losses. But if you have a steel-lined stomach and confidence in your trading game, it could lead to significant gains in the long run. Good luck.
