Trading momentum stocks are the best style of investing to make large returns in a short period of time. But it also involves high risk if you don’t know what you’re doing. If you don’t know the rules of trading these type of stocks, you will lose a ton of money. Every trader should have these rules printed out in front of them while they trade so they won’t be broken. Here are 13 rules all traders should follow for trading momentum stocks:
1.Pre-Plan Your Entry and Exit Strategy
Before you put on a trade, you should always know what price you will enter at, what price you will stop out at if the trade goes against you, and at what price you will start taking profits. You cannot take a trade if you do not know these three things. You also need to figure out if you will scale in and out of your positions, and how you will manage the trade. Don’t wing it and figure out things as you go on.
2.Define and Manage Your Risk
Trading momentum stocks can be risky because momentum stocks move fast and are volatile. Before every trade, you should know how much money you are risking on the trade. $100? $200? You cannot play poker without knowing how much you are going to risk. You would never go all in with a 2,6 hand. The same is true for trading. Defining and managing your risk appropriately is critical.
3. Buy on Dips, Sell into Strength
Most new momentum traders sell on dips and buy on strength. It is our nature to want to be a part in a stock when it is going up, and get out when it is going down. To be a successful trader, you have to do the opposite of what your instincts tell you to do when you are in a trade. You have to take profits when things are looking great and everyone else is chasing, and buy when everyone else is panicking out.
4. Identify Key Support and Resistance Areas
Knowing key price levels where the stock might reverse is essential for trading momentum stocks correctly. Knowing where the key support and resistance areas are, on the intraday and daily charts, before you enter a trade will allow you to enter and exit and the correct prices, increasing the probability the trade will play out in your favor.
Volatility can be your best friend or your worst enemy. It can really burn you if you are a chaser. If you buy too high or sell too low, there is a high probability the stock will reverse on you right after you enter. Always wait for a pullback, or wait for a better setup on a different stock. There will always be another opportunity in the markets. If you have issues chasing stocks and dealing with FOMO, learn how to conquer the habit in this article here.
6. Never Add to Losers
Traders add to losing positions with the idea that they will have a bigger winner once the stock reverses the trend. This is rarely the case because the reason traders are in a losing trade is because they are on the wrong side of the trend. Adding to losers is fighting the trend, and most of the time will just make your losing trade even bigger.
7. Use Margin Correctly
Margin can be the momentum trader’s best friend or worst enemy. It has the potential to make your winners a lot bigger, but also can increase the size of your losers. If you get stubborn on margin when trading momentum stocks, you will risk blowing up your account in a very period of time or even going into debt to your broker. For tips on how to use margin correctly, check out this article here.
8. Avoid Illiquid Stocks
Illiquid stocks suck for momentum trading, They have huge spreads, rarely follow through, and are choppy. You should avoid trading stocks with less than an average of 1 million shares of trading volume unless there is a catalyst that is bringing in high relative volume into the name. Illiquid means that no one is watching it. And if no one is watching it, there aren’t enough buyers or sellers to make the stock make a big move.
9. Trade Proven Patterns
It easy to treat trading stocks like gambling. You can buy a random stock at a random time and make money, and feel like it’s easy. The reality is that you just got lucky, and the only way you can consistently extract income is by trading a strategy and patterns with an edge. Make sure all the strategies and patterns you trade can consistently generate income for you. Just because you make money once doesn’t mean you can do it consistently.
10. Trade Stocks With Momentum History
Stocks tend to have self-fulfilling prophecies. If they made a big move in the past, it is likely to do so again if it sets up correctly. Look at stock’s daily chart to see if it has a large range daily candles in the past where high relative volume comes in. If this is the case, it will likely happen again if it gaps up or down with a catalyst.
11.Focus on the Daily Chart Trend
The big picture trend of a stock is seen on its daily chart. This should be the primary influence on your bias on a stock. Is the daily uptrending? Downtrending? Going sideways? Day traders will often make the mistake of making a trade counter trend to the daily chart. Intraday setups have a low probability of working if they are not aligned with the stock’s daily chart trend.
12. Know the Stock’s Catalyst
Momentum stocks will often gap up and gap down in response to company news. You should always know what is causing a stock to move before you trade it. Some catalysts are not conducive to bringing momentum into stocks. Here is a list of the best catalysts for bringing momentum into stocks so you will know which to trade, and what to avoid.
13. Trade Without Emotion
Fear and greed are the two primary emotions that result in the majority of your trading mistakes. Eliminating them is easier said than done. Much of your emotion will stem from making and losing money. An easy way to reduce emotion in your trading is to reduce your position sizes, as you will focus less on the money you are making or losing and more on signals of the market.