What are Momentum Stocks and How to Trade Them

Momentum stocks refer to companies seeing a lot of interest in the financial market for an extended period of time. These companies are also known as hot or growth stocks.

They differ from other types of companies like Procter & Gamble and General Mills that are known for their earnings.

In this article, we’ll look at how you can day trade momentum stocks, their examples, and how to identify them.

What are momentum stocks?

As mentioned above, momentum stocks refer to companies exhibiting a lot of interest among the trading and investing community for one thing or the other.

For example, companies in the electric vehicle industry are hot these days because the world is on a fast transition from fossil fuel-powered cars. Similarly, cloud computing stocks are being loved today because companies are attempting to move from on-premise storage to the cloud.

Momentum stocks have several characteristics like:

  • In high-growth industry – They are usually disrupters targeting large industries.
  • Revenue growth – These are firms with a high quarter-on-quarter and year-on-year revenue growth.
  • Not profitable – While some momentum stocks are profitable, some are not. For example, while Tesla is the biggest automaker, its profits are relatively limited.
  • No dividends – Many momentum stocks do not pay dividends. Instead, they use their money to fund their growth.
  • Large swings – Unlike value stocks, momentum stocks tend to show huge swings on a daily basis.

Momentum vs value stocks

Value stocks are the exact opposite of momentum stocks. These are companies with solid earnings, pay dividends, and tend to have a strong market share in their industries. For example, a value company like Berkshire Hathaway has holdings that dominate some industries. Similarly, a company like Sysco is known well in the agricultural industry.

In the past few years, low-interest rates have pushed more investors and day traders to the momentum side.

In fact, many momentum stocks have outperformed their value peers. This is despite the fact that most of these value stocks have stable earnings, pay dividends, and have a substantial market share in their industries.

The chart below compares the iShares Edge USA Momentum Factor ETF (MTUM) and the Vanguard Value ETF. As shown, the momentum ETF has done better in the past five years.

Momentum vs value ETFs. Chart from Tradingview

Examples of top momentum stocks

There are hundreds of high-quality momentum stocks in the United States. Some of the best-known ones are:

  • Tesla – Tesla is a leading manufacturer of electric vehicles (EV) in the US. It is the most valuable automaker in the world with a market cap of more than $800 billion.
  • Nio – Nio is a leading EV manufacturer in China. It is giving Tesla a lot of competition there and is valued at more than $100 billion.
  • Roku – Roku sells a TV streaming device but is also a leading player in the television advertising industry. It is valued at more than $50 billion.
  • Nvidia – It is a leading manufacturer of computer chips with a market cap of more than $300 billion.
  • Adobe – Adobe is a leading SAAS company that provides creative solutions.

How to day trade momentum stocks

There is no major difference between trading momentum and value stocks. Therefore, you should follow a few steps when trading these companies.

Entry and exit point

First, you should have an entry and exit plan for every trade that you enter. An entry plan involves several aspects, including the reasons why you are buying or shorting a certain stock.

This could be because of major fundamental news like earnings and a proposed merger and acquisition. It could also be a technical factor like the formation of the moving averages and the Relative Strength Index (RSI).

Define your risk-reward ratio

Second, you should define your risk appetite for every trade. Ideally, for starters, it is recommended that you should not risk more than 3% of your trading account per trade.

For example, if you have a $10,000 account, you should not risk about $300 for every trade you enter. The goal of doing this is to limit your loss exposure since a trade can go in either direction. This is particularly true among momentum stocks because these firms are usually more volatile, as mentioned above.

Buy the dips

Third, in most cases, momentum stocks are good for buying on the dips. This simply means that you should buy when the stock experiences a sharp decline.

The theory goes that, in momentum stocks, when a stock declines slightly, many retail traders will rush for their exit. This, in turn, creates a good entry point for bullish buyers.

The chart below shows how the decline of Tesla shares has created good entry points.

Identify support and resistance levels

Fourth, always identify key support and resistance levels before you trade. A support is usually an area where the price of a stock struggles to move below while resistance is a ceiling where it struggles to move above.

These are usually the most important areas when trading. Therefore, you should always identify them before you initiate a buy or sell trade.

A good way to approach it is to join swings in several timeframes. For example, you should join them in the daily, hourly, and weekly charts.

Don’t leverage too much

Fifth, always avoid being overleveraged. Most online brokers in the United States offer leverage to their traders. This simply means that they give loans to amplify their traders’ positions.

This leverage is a good thing. However, you should use it wisely because it can lead to significant losses if trades go south.

Summary

In this article, we have looked at what momentum stocks are, how to identify them, examples of such stocks, and some of the important tips you can use to trade them. In summary, you should always be careful about these stocks, buy the dips, and always manage your risk well.

External Useful Resources

  • The Advantages and Pitfalls of Momentum Trading – RagingBull

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