What is Momentum Trading

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This is a guest post by Howie Bick.

Diving into momentum trades: why they move, and why they move fast.

One of the ways people trade and look for ways to produce returns, is by looking for momentum throughout a market. Momentum when it comes to trading, means where there is an abundance of trades going in one direction, causing the price of a stock or financial vehicle to follow, either down or up. momentum trades are one of the common drivers people look for in order to find the next winning or profitable trade, or to look for to precisely position themselves. Oftentimes, it’s behind some of the largest stock moves, and sometimes it’s the sole reason for the increase or decrease behind a particular trade. Momentum is an incredibly interesting study when it comes to trading, and anticipating it can prove to be incredibly profitable, but feeding into it can be a dangerous game.

What is momentum?

Momentum is when a stock, or a large group of individuals, traders, company’s, funds, or institutions are one side of a particular trade. When there are enough people or company’s behind a particular trade, and buying or selling that trade, it causes the price to rise or fall. Whether it’s because of a new announcement, a new deal they’re pursuing, new earnings reports, or anything that might have an effect on a company’s stock, Momentum can be a result of many different things.

What does momentum do?

Momentum behind a particular trade, can cause a stock or financial vehicle to rapidly rise, and spike in price, due to the laws of supply and demand. When one side of a trade sees an incredible influx of parties willing to both buy and sell, there is only so much supply out there to meet the demand. What happens with momentum trades, is the supply side of the equation gets absorbed, while the demand side of the trade is still there, still strong, and still looking to buy. When the available shares up until a certain price point are purchased, the price starts to rise, as more and more parties are looking for shares to buy, with less of a supply available to purchase. With the laws of supply and demand in play, when there is a large demand, and less supply, the price of the asset or stock rises with it. Ultimately it comes down to how many parties are there on a particular trade that are ready, willing, and able to purchase, and what are they willing to pay. If parties on one side of a trade are willing to pay whatever and care less about price, the price of that asset, stock, or company will go as high as it can go. The reason why it can go so high or to any price people willing to buy will pay, is because of that momentum.

The value moves to the momentum.

When a trade is so one sided that there is an overwhelmingly majority in one side than the other, the real value begins to depart from the event that caused the trade, whether it be fundamentals, earnings, or a new report, and more so into the momentum itself. The Momentum can push a stock or a company up or down so far, that the value in the trade is no longer about the fundamentals, the growth prospects, or the recent news event, but is in the momentum itself. When that happens, and the momentum becomes where the real value is, then the trade begins to get scary. That’s when the red flags need to be raised, and you need to start being very cautious, and very careful, and really understand why you’re in a particular trade.

Keeping The momentum going.

The main way momentum sustains itself or continues, is through having a continuous flow of new entrants to one side of a particular trade. This means more and more people, companies, private equity funds, hedge funds, institutional investors getting behind a trade, and willing to invest their money, and their capital into it. Without a steady stream of buyers who are willing to purchase or act on the side of a particular trade, the momentum begins to lose steam.

What happens next?

A momentum trade can only go on for so long, or until there are no more buyers or sellers on one side of a price level of the trade. Once there are no more buyers or sellers at a particular price point, that’s when the price starts to fall to a place where there are buyers and sellers willing to transact. With momentum trades, the number of parties on one side or the other, can change very quickly, as people begin to take profits, minimize their losses, or decide to exit the trade. This means, as the number of buyers or sellers at a particular price begin to change quickly, so does the price.

Seeing the writing on the wall.

When you decide to participate in a momentum trade, it’s very important that you keep a very close eye on them, and monitor them closely. It’s a trade or a scenario where you can make a lot of money quickly, or lose a lot of money quickly. If you decide to participate in one, it’s very important that you watch the number of buyers and sellers on each side, you see how they are transacting, if they’re changing, and what that information is telling you. That information is ultimately what is driving the trade, and what is influencing the price of a company, it’s shares, or other financial instrument.

What happens when there is no more momentum?

When a trade begins to lose steam, or begins to lose momentum, the laws of supply and demand come back into play. What this means, is as the supply of shares for sale begins to outweigh the demand at a particular price point, the price begins to fall or drop until there is adequate demand. Depending on the trade and what caused the momentum that moved the chart, there can be very little long term demand on the other side, or adequate demand to sustain the move. That’s why it’s very important, if you participate in a momentum trade, that you keep a very close eye on it. That way, you can try to anticipate and act before there is no momentum left in the trade, and the price begins to fall.

Conclusion.

Momentum trades are an incredible topic to study, watch, and analyze. There are lots of factors that affect the way momentum trades play out, and the way they go. Whether it’s news that comes out, a rise in earnings, or a fall in production capacity, Momentum is what ultimately drives a particular trade, and influences a bevy of trades on one side. Momentum has the capability to push a chart up or down incredibly high, or incredibly low, very quickly depending on the number of buyers and sellers on either side. The laws of supply and demand play an important role in momentum trades, as it ultimately drives the value, and the price of a company in the midst of a momentum trade. As new buyers or sellers begin to enter a trade, the price of momentum continues to rise with it, as less and less buyers or sellers are on one side of the trade, the price begins to fall or rise. With momentum trades, it’s very important to keep a close eye on the number of buyers and sellers on each side, as they ultimately become the main value proposition, and the main driver of value. As the trade begins to fizzle, or the momentum begins to dry out, the trade ultimately goes with it. It’s incredibly important that you try to read the writing on the wall, anticipate what might be happening, act accordingly, and avoid being the one holding a fizzling momentum trade.

Howie Bick is the founder of The Analyst Handbook. The Analyst Handbook is a collection of 16 guides created to help current and aspiring Analysts advance their careers. Prior to founding The Analyst Handbook, Howie was a financial analyst.