The three main momentum trading strategies that traders use are the following:
- The first is to go to long stocks with high price momentum and short stocks with low momentum.
- The second is to enter into pairs trades where you long one stock in a sector with positive relative strength while simultaneously shorting another stock in the same industry that does not correlate well with the first stock.
- Lastly, some traders like to open positions on stocks whose earnings can be used to predict future growth.
But what exactly are these strategies? How do they work? When should you trade them? And why would someone want to utilize them at all? We will answer these questions throughout this article, so continue reading if any of these apply to you.
First trading strategy
The first strategy is relatively straightforward in that you are simply betting on the fact that stocks with high price momentum will continue to have positive price movement. The thought process behind having this viewpoint involves believing that the past performance of any stock’s returns is an indicator of future performance, although this is not always necessarily true. You can utilize this strategy both for short-term trading or long-term investing. Still, the time frame you should do it varies based on your belief about how strong momentum really is and whether you genuinely believe it can reverse course at some point.
Another way to utilize the first method would be to take advantage of companies that pay out high dividends because these tend to attract momentum traders. As people buy into their high-yielding stocks, the share price will continue to increase, leading to even more enormous dividends down the line.
Second trading strategy
The second momentum trading strategy, pairs trades, is much more complicated. To work effectively, you need to know which stocks are moving in tandem and the underlying sector movements. For example, if you were to go long Apple stock and short Google stock, you would be betting on the fact that Apple’s stock price will outperform Google’s stock price due to their different business models.
However, this trade would only work if you believed that both stocks were in a downtrend or consolidation phase. Otherwise, you would simply be going long AAPL stock already in an uptrend, thus defeating the point of entering into this type of momentum trade.
Third trading strategy
The final part of trading with momentum involves utilizing earnings surprises to your advantage. It works because if a company beats their estimated earning per share (EPS) for that given quarter, they are expected to have higher momentum in the weeks following this announcement to help justify the higher EPS estimate. If they miss their EPS by a wide margin, however, then it is likely their stock price will suffer due to lower demand.
This sentiment continues until the next quarter, when you can place another bet based on whether they meet expectations again. While this may seem like an easy way out for traders, it is essential to remember that earnings surprises are not always indicative of future stock performance and should be used as only one tool in your momentum trading arsenal.
So, when is the best time to use these strategies?
That depends on various factors, including your risk tolerance, investment time horizon, and knowledge of the markets. If you are relatively new to trading or investing, it would be best to stick with more straightforward strategies like going long high momentum stocks or using earnings surprises as an indicator for future growth. Conversely, if you have a lot of experience trading and are looking for more advanced techniques, then pairs trades or utilizing sector movements might be more suited for you.
Regardless of your chosen strategy, it is essential to be aware of your emotions and behavioural biases when trading with momentum. Knowing how you may react in certain situations will allow you to make the right decisions that much easier. Follow this link to find out more.