"The trend is your friend."
So say the momentum traders, the action junkies, and the rocket-stock aficionados. When a stock is going up, they posit, you should buy because stocks have momentum. If they've gone up in the past, they tend to keep going up. But is that really true?
Momentum trading is the practice of trying to make money by trading stocks along with a trend. For example, if a stock is soaring after releasing a stellar earnings report, a momentum trader might try to buy shares and ride the stock's price higher. Or, for a very relevant example in the modern stock market, if a stock's price starts to rise because of a rumored short squeeze, momentum traders might buy shares with the hope that the short squeeze continues to push the price higher.
Short Squeeze
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Risks and drawbacks of momentum trading
In a nutshell, by using momentum trading you are counting on a certain trend to continue. However, there are absolutely no guarantees. Trend reversals happen all the time, and momentum doesn't last forever. An ideal momentum trade would involve buying a stock on the way up and selling it at (or just before) its peak. As anyone who has tried it can tell you, that is much easier said than done.
Trend Reversal
In his classic text on the advantages and disadvantages of various investing strategies, Investment Fables, Aswath Damodaran of the Stern School of Business at NYU states his doubts. After crunching the numbers, he concludes that while it's true in general that a stock that has been going up keeps going up, "timing can make the difference between success and failure" when you trade on momentum.
When a stock rockets on a better-than-expected earnings release, for example, seconds can count. Good news can spark a nearly instantaneous rise in price, and the profits go only to the quickest clickers. Gun-shy traders face a different problem. Stocks that have risen for six months straight tend to continue rising for a while, but if you wait six months to identify the "trend," you have by definition forgone all the profits to be made while the trend was forming.
In short, momentum trading is risky. Citing statistical data, Professor Damodaran further explains that, "Momentum stocks have an average beta almost twice that of the rest of the market ... and are much more volatile."
The problem is that this process works both ways. Traders who buy a stock because it's going up may quickly turn around and abandon the stock when it stalls. At that point, a tidal wave of selling starts. Sellers, desperate to get out of the stock, will offer to sell it for progressively lower prices, forcing the price downward.
The bottom line on momentum trading is that it is a higher-risk way to put money to work in the stock market. And it's certainly a form of trading, not investing. Momentum trading can be a good way to make money when things work out, but it can quickly result in big losses if things go the other way. Invest accordingly.
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