The Nuts and Bolts of MOMO (Momentum) Trading

Warren Buffett once said, “Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble.” That’s sage advice for the meme-stock-trading crowd that emerged in 2020.

This new group of traders introduced a type of momentum that’s been atypical in the financial markets. First, traders hear about a stock that’s getting a lot of buzz from an online trading group. The FOMO (fear of missing out) and YOLO (you only live once) crowds decide to go for it. A bunch of traders band together, jump in to the stock, and push prices higher. This continues until enough sellers show up to reverse the price move.

Mashed together, FOMO and YOLO can create momentum, or MOMO—but it’s not the typical kind. When you jump in to a trade based on unreliable sources, it’s usually not a viable momentum-based trading strategy. It’s just herd-mentality guessing.

Momentum trading strategies

In theory, MOMO trading can be a long- or short-term strategy. If there’s enough juice for a price move to continue, it could be worth jumping in. Momentum traders typically start following a trend when a stock shows signs of strength, and they exit the trade when momentum starts to slow. How is this different from the momentum behind a FOMO trade? 

Well, MOMO trading isn’t about finding the latest meme stock—nor about jumping in to a trade on a price move that has no fundamental basis. It’s more about looking at how strong a trend is, waiting for a setup, and getting in to try to take advantage of that strength.

If you feel tempted to jump in to a trade based on its trend, first take a step back and figure out whether the price move may still have room to run. It’s no fun getting into a trend trade at the tail end of its move.

A FOMO or YOLO trade is likely to look like the chart in figure 1—short and quick. Sure, it’s easy to see in hindsight. But in real-time trading, it might look like any momentum trade. How do you know the difference? The real test lies in the sustainability of a price movement, and that means waiting for a setup to appear on the charts. And yes, you may have to be patient. 

Approaching momentum trading with a three-step process

Deciding whether a trend is sustainable is a challenge if you’re also juggling fear and greed. Consider a three-tiered, top-down approach to help you view momentum more strategically. It all starts with asking three questions.

1. What do you want to trade?

Before placing a trade, get an overall view of the market. Here’s a place to start:

• Fire up the thinkorswim platform.
• Select the MarketWatch tab.
• Select Visualize in the submenu to get a heat map of the broader market.
• Select Indices (listed under All Watchlists).
• Expand each index to see how sectors are performing. 

This gives you a visual idea of which sectors might be outperforming or underperforming on any given trading day.

Once you’ve figured out which sectors you might want to trade, identify a handful of stocks that are potential trading candidates. If a specific sector is outperforming, traders typically look for individual stocks within the sectors that are moving in sync. Think of them as the generals.

While still in the heat map, do a quick analysis to see if any key stocks are showing signs of momentum and are likely in the early stages of a trend. Then select any of the symbols and go to More info on symbol > Quick Chart. These are the stocks traders might consider adding to their watchlist. Think of them as the soldiers.

2. Where in the trend are you?

There’s no right or wrong way to identify a trend. But there are different tools that can help you figure out if the trend is beginning, developing, or maturing. Some drawing tools to consider include price channels and support and resistance levels. Traders often also consider the stock’s volume when making a trading decision. You can find all these on the Charts tab on thinkorswim under Drawings > Drawing Tools.

Traders commonly start with a longer-term chart that goes back six months or a year. Figure 2 is a one-year chart that clearly shows an upward channel. Let’s walk through the early stages of this channel to determine when a trader might potentially enter a trade.

3. When do you get in?

There’s no perfect time to enter a trade; however, using multiple time frames for your charts can help you choose. First, start with a longer-term chart. The starting time frame depends on whether you’re a short- or long-term trader. It should go back just far enough to see which way prices are trending and if they’re doing so with enough momentum.

Going back to figure 2, in mid-October, the gap up on heavy volume would’ve been the first indication of a momentum opportunity. But to avoid false signals, traders generally don’t jump in at the first sign. Instead, dig deeper to see if this is likely to be a short-term move or if it signals longer-term momentum by zooming in on shorter-term charts. 

Next you could zoom in on a 30-minute chart for the day price bounced off support, plus the following few days. Does the trend coincide with what you saw on the daily chart? In this case, it does. But let’s take it one chart further to confirm. 

Pull up an even shorter time frame, such as a five-minute chart. Notice that when price bounced off the trendline, it did so on higher-than-average volume—a good sign confirming the trend’s momentum. From this point, bounces off support levels, high-volume price spikes, and so on may be entry points to consider. 

When do you get out?

That all depends on how price progresses. At some point, you may be able to extend your channel to the right. The upper-channel line could function as a resistance level, or there may be other resistance levels (such as previous highs) that you might use to help decide when to exit the trade. In this example, price moved in an upward channel. A breakout above the upper channel on high volume could potentially be an exit point.

Of course, many traders consider setting a stop order below significant support levels. That way, if price should move in the opposite direction, the trader has a way to potentially manage downside risk.

Following this three-step, multi-time-frame approach when planning trades could help prevent hasty decisions. And analyzing price movement from different perspectives may give you a more objective view. This, in turn, could help you trade more logically and ultimately help prevent you from following the wrong crowd.