Momentum in the context of trading and investing, means to trade in stocks that have a high probability of moving up rapidly. Such stocks tend to rocket and achieve 100 to 200% or growth in a short span of one to two years.
What is momentum stock trading?
Theoretically speaking, momentum investing and trading works by focusing on identifying and buying stocks that have the potential to rise significantly within a short span. A successful entry leads to the next steps; managing risk and managing the positions. Being active and watchful in the market for signs of potential weakness ahead. A skilled trader strives to enter at the right location and focus on risk first while being very active to lock in profits on time. The key is to take profits before the market turns around and reverses all gains.
How does Momentum trading work?
It all starts with being able to identify potential momentum stocks. The four-step process starts with;
- Having a proven trading plan
- Having a Trading Strategy
- Actively managing risk
- Being disciplined and consistent
Markets are very much akin to the constantly changing and unpredictable weather. Phases that turn from warm to pleasantly cold. Cycles that transform swiftly from a violent to a turbulent storm. It’s all a part of the various cycles experienced in nature that are often typical and predictable in their patterns. The seasonality plays out all the time and is often interlaid with unpredictability as well.
“In many ways the stock market is like the weather. If you don’t like the current conditions, all you have to do is wait a while – Low Simpson”
The market too has a similar character and structure. Peaceful and calm markets can shock, surprise, and turn chaotic and violent in no time. A perceived calm market that may transform swiftly and move significantly in one direction taking everybody by surprise. This burst of energy settles down quickly and even turns into a deep downfall. Downfalls that reverse quickly and shift into a rapidly trending up-move. Violent & unpredictable markets often behave worse than a raging bull, causing cycles of fear, anxiety, greed & euphoria, all of which are constantly visible in the markets.
So how does one handle and profit from such unpredictability?
The key lies in establishing and working with a well-defined set of rules and a comprehensive plan.
What is a Trading Plan?
A trading plan is a blueprint for operating independently in the markets. It’s where you define everything. Your style of trading, how much trading capital you will allocate, what will you trade, when will you trade, how you will manage risk when you will take profits, and all the other things around your trading activity.
In the markets, my plan is to seek out and only stick to momentum stocks. It’s the zone that works best for me. I only trade in one direction and that means going long. Each person is unique and has their own personality, and my plan might not appeal to every investor or trader. Someone young may seek and enjoy the adrenaline rush and get a thrill out of being in the thick of the action all the time. A Nifty futures intraday trader may have a completely different personality, trading different patterns, and have a unique style of trading.
Basically, a good trading plan helps to narrow down your focus. You learn to focus all your energy on your defined trading style while eliminating all noise in your trading game. You strive to stay away from being overwhelmed by trading any other random stocks, instruments, and strategies.
Making a plan can be simple and will depend on where you stand in your investing and trading journey. Depending on your study and experience of fundamental or technical patterns, you may want to explore and learn about indicators, price action techniques, specific trading strategies and then prepare and come up with a plan that works for you.
A good outline for a Trading Plan would be to define;
- Trading Goals
- Your Trading Patterns
- Risk management
It’s highly common for investors and especially traders to have a huge internal battle with their self-confidence. Second-guessing trade setups, hesitating to enter the trade, and often exiting winning trades due to fear. It’s a constant battle that’s highly charged with emotions.
A clear set of rules helps to define the trades that can be taken. Gaining clarity by writing down the rules, the criteria for the entries, when to exit, and where to place stops all go a long way in helping to manage the trading activity and staying free of emotional decisions.
The act of defining rules helps to guide decisions and to establish consistency and discipline. So even a simple one-page plan that’s easy to understand, is a good starting point. The hardest part often lies hidden in the execution and in having the discipline to stick to a defined plan. A step-by-step guide to making a trading plan is in the works and will be shared across soon. Meanwhile, let’s look at how one can find out the stocks that are ready to rocket.
How to identify Momentum stocks?
The essence and the key of trading in such an environment lie in gaining a better and deep understanding of the nature and structure of markets. Understanding the structure is often underrated, yet this ability is the key that helps to understand and identify the strong contenders that have the potential to give outsized returns. Market structure is what defines whether it’s the right time to invest or it’s time to cool off by sitting in the stands and watching the fun from the sidelines. As a side benefit of being on the stands, you end up saving and conserving your financial and emotional capital.
Markets typically cycle through the following four major stages
- Forming a base – Basing stage
- Rising Trend – Advancing stage
- A phase of consolidation- Topping stage
- Downtrend – Declining stage
The markets are like emotional creatures. Emotions quickly change from optimism and euphoria to anxiety, anger, and panic as the market gyrates from the trenches to its euphoric peaks. Within these above structures, the market gives enough clues on when the shift is likely to occur. The market fluctuates and moves through these large cycles.
It all begins with learning to understand the context of the market and to follow the defined trading plan and strategy. Learning to trade in the direction of the trend is the rule, for each and every trade. Each time a trend establishes itself you must be clear of the next decisive action steps.
- Which stock to buy?
- When to enter?
- How much to buy?
- When to exit?
Managing risk effectively.
How one manages risk determines the success and failure of a person. Thinking risk first and taking decisive action to cut losses is mandatory and this rule has no exceptions.
It all begins with knowing and identifying stocks that are in a confirmed uptrend. Stocks that have turned after forming a solid base and foundation need to be nurtured and watched. Stocks that start exhibiting strong characteristics of becoming super performing stocks.
Learning to trade momentum begins with being able to identify potential candidates that will continue to perform and move spectacularly.
How do you identify potential momentum stocks?
The only way to profit from markets is to be able to identify stocks that are moving up. Obviously, stocks that are moving sideways or going down are useless for our purpose.
So the criteria are to filter the universe of stocks and shortlist candidates that meet the following criteria. The stock must have a positive selection score and the majority of the following conditions must be met.
- The stock must not be an F&O Stock
- It must have a free float of fewer than 5000 crores
- The stock must be trading over Rs 30 in price
- It must be within 25 % of its 52 week high
- It must be up more than 100% from its 52 week low
- Stock must be making new highs within every 26 weeks
- The stock must be trading above the moving 50 & 200 moving averages and the averages must be rising.
Shortlisted stocks that meet the above criteria usually are in a confirmed uptrend and show proper setups to fit the buying criteria for a momentum stock.
A master Momentum trader works with the skill of a patient predator. The hunter knows and has adequate skills to identify the repetitions of the market patterns. Being able to identify and act on such repetitions of the market and profiting from it consistently is the key to survive in the markets.
“The Stock market is a device for transferring money from the impatient to the patient – Warren Buffet”
Market price and its movements have a distinct repeating tendency. Stocks that move in a direction leave ample clues for a skilled trader to zero and double up upon the right stocks. The edge is in knowing and sighting the right opportunity and entering it at the right time.
Next you need to be clear on the risk part, well before entering the stock. The best patterns of entry offer a low risk entry in strong moving stocks. By finding stocks that are having strong potential to be movers, you are in essence managing risk by filtering out the right direction.
How do you manage risk;
- By being clear on when to buy the stock
- By knowing how much to risk per trade
- By knowing how much to buy
- By actively managing your trades
Risk management is all about knowing where you will exit, when you are proven wrong and where you will exit when you are proven right. You need to be clear with the profit and loss ratio. The risk is calculated by the potential profit to potential loss, where the profit forecasted ought to be a minimum 2x of the initial risk taken. Anything less is unacceptable and will not justify taking the trade.
Finally, the art and skill of taking profits by managing the profitable exits in the right manner come over time and with practice. This skill improves and refines over time spent taking real trades with real money because that’s where emotions are involved and that’s where the role of mindset & psychology display the true grit, discipline, and character of the trader.
Profits generally come over a series of disciplined and consistent trades. Being consistent with risk, accepting and moving on from a series of losses, and staying laser-focused on the process of trading are all “not so secret” ingredients of successful trading.
A successful momentum trader learns the hard way that profits come through a series of trades. Profits are a by-product of following the process and are never the true goals of any successful trader. A series of trades may often witness a series of losses in which risk is perfectly managed. Eventually, when the market moves, it takes off with you. If you are disciplined, the markets will be benevolent enough to pay you off handsomely. Profits come as a by-product to the one who establishes faith and conviction in their system and trades big sizes with ease and confidence.
Master traders know the irony that trade at a high price on the right stock is a better trade at the right time.
Momentum in the markets is like fire in the dry forest during peak summer. A small spark is all that’s needed to start to burn that spreads rapidly at great speed while moving with great fury.
Similarly, the fire in the stock will propel it higher until the stock runs out of fuel.
Here are some of my favorite books on investing and momentum trading
- How To Trade In Stocks by Jesse Livermore
- How To Make Money In Stocks by William J O’Neil
- Trading For A Living by Mark Douglas
- Trade Like A Stock Market Wizard by Mark Minervini
- Zen In The Markets by Edward Allen Toppel
- Trading From Your Gut by Curtis Faith
- Momentum Masters. A Roundtable Interview Of Super Traders by Mark Minervini
- Trading In The Zone Master The Market With Confidence Discipline And A Winning Attitude by Mark Douglas
Momentum trading flies in the face of common logic. Momentum trading concepts run contrary to a typically dispensed and oft-cited wisdom ”Buy Low and Sell High”. It operates based on “Buy high and sell higher”
Most amateurs will shy away from buying the stock when it’s at an all-time high. This level often gets perceived as being expensive. Moving forward several weeks ahead, the same stock has experienced a move of over 80-100 % and that old level looks so cheap in hindsight. That often causes regret and “I told you so” syndrome that releases ego pampering calculations of “if I would have bought there”, I would have been sitting on my cool million dollars profit by now. So much for notional profits with which you can pay zero-sum bills.
One needs patience, perseverance to develop and master the skills. A successful trader gets developed over time. It takes commitment, complete dedication, and intelligent hard work. This is what makes it out of reach and as much as over 95% of traders are victims of failure.
Learn to develop the required skills. Begin now to Invest in yourself. Take action daily to move forward. It’s a journey and being successful at trading and investing starts with believing in yourself and your abilities. This is the starting point. Cultivating the right mindset, gaining enough mental strength, and making profits are the results of long-term investment in yourself. Rich dividends and profits come over time when enough effort is mixed with discipline, consistency, and perseverance.
An Investment in Knowledge pays the Best Interest
– Benjamin Franklin
What are you going to do to build and develop your expertise?
Start by going through the above books, one at a time. Take time to read, re-read, digest, and implement. Follow your interests, see what works for you. Each person is unique and develops on the path based on their personality, experience, and interests. Stay on the path, stick to it and rich rewards will await you down the road.
New to the Stock Markets ? Read the Introduction to the Indian Stock Market