Trading | March 12, 2021

Go With the Flow: How to Trade Momentum

Momentum traders operate under the assumption that an asset price moving strongly in a given direction will continue to move in that direction. A price trend can reverse at any time, of course, but it’s less likely to do so when momentum is strong or accelerating.

But what clues might suggest that a surge of momentum is sustainable? Here are a few indicators I like to use—along with strategies for how to deploy them.

1. Trading volume

As a friend of mine likes to say, “Volume is the rocket fuel for further price appreciation.” That’s because when a stock’s trading volume is above average or increasing, it can be an important signal of traders’ commitment to the current direction (see “Time is of the essence,” below). Alternatively, when volume is below average or falling, momentum may be waning, and a reversal could be in the offing.

2. Moving averages

Traders can use moving averages—a calculation of a stock’s average price over a set number of days—to determine if a stock is trending higher or lower, or remaining relatively steady. When a stock breaks above or below a moving average, it could signal the start of a rising or falling trend. For momentum traders, the question is which moving average to use.

When a stock breaks above its five- or 10-day moving average, for example, it may be a terrific opportunity for short-term gains. If you enter such a position, be sure to set a stop order for just below the moving average to help minimize your loss in the event the momentum doesn’t hold. Momentum can be fleeting, so such positions must be managed actively as they can quickly unwind.

Those inclined to hold on to a stock longer—or who don’t want to manage a trade too closely—will want to see the price break through the longer-term averages. For instance, a stock that breaks through a 50- or 200-day moving average is more likely to convert momentum into a longer-term trend (see “Time frame matters,” below).

Time frame matters

FedEx (FDX) broke above its 10-day moving average in late April 2020 before pulling back (see in the chart below). In May, it followed up with a longer run after breaking through its 10-day and 50-day moving averages (see ). However, it wasn’t until July that it broke above its 200-day average (see )—a strong indicator that positive momentum had unleashed a new uptrend, which is indeed what followed. Also note how the volume spiked the day it gapped higher and through its 200-day moving average (see ).

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve. Screenshots are historical in nature. Past performance is no guarantee of future results.


3. News and commentary

Qualitative inputs may also be useful when trading momentum. When I’m thinking of entering or exiting a stock with strong momentum, I always look to see if there’s any upcoming news that could knock it off its recent trajectory. For example, a pending earnings announcement could easily derail the stock if the numbers disappoint.

I also check Twitter as a crowdsourcing function, looking to see what traders I respect are saying about a stock. This can provide some timely clues about whether enthusiasm for a stock may be overblown or justified based on these collective sentiments, and I’ll take particular note of traders advising to take some profits at certain price points.

Protect yourself

Often, a stock retreats after a strong run because traders are waiting to see if the price breaks below its moving averages and volume declines. There’s nothing wrong with reducing or closing out some positions during these times of consolidation.

Another strategy is to reduce the size of your position in a trade as the price breaks below certain moving averages (see “Different strokes,” below). When the price breaks below all the moving averages, however, it’s a pretty good sign that the positive trend is broken at that point.

Different strokes

When Tesla (TSLA) was outperforming last year, you could have:

  • Used the five-day moving average as a trigger to buy Tesla last April (see in the chart below) and then sold a portion once it broke below the line more than a week later (see ).
  • Sold more—but not all—after the stock broke through its 20-day moving average in August (see ). This would have still enabled you to profit once the stock regained its momentum later that month (see ).

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve. Screenshots are historical in nature. Past performance is no guarantee of future results.

No matter how long you’re in a momentum trade, you should build in protection against unexpected price declines. Setting a stop order below one of the moving averages is a good way to do this—just be aware that it won’t protect you against after-market or pre-open moves, and stocks with negative news often gap down. If you’re using a standard sell-stop order—which becomes a market order once your sell price is triggered—you could end up selling far below your target price. If you’re using a stop-limit order—which will execute only at the price you set—you could end up not selling at all if no buyer is willing to meet your price.

Even with these risks, trading momentum can be a profitable strategy for both short- and long-term gains. Using a combination of volume, moving averages, and other inputs should give you some good ideas on where to start—and when to hop off before the engine sputters.

What You Can Do Next

  • Want more breakdowns of popular trading strategies? Watch new episodes of Schwab’s Trading Up-Close.