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Momentum trading is a type of short-term, high-risk trading strategy that requires a lot of skill and practice. While momentum trades can be held for longer periods when trends continue, the term generally refers to trades that are held for a day or several days, on average.

Momentum traders strive to chase the market by identifying the trend in price action of a specific security and extract profit by predicting its near-term future movement.

Looking for a good entry point when prices fall and then determining a profitable exit point when prices become overbought is the method to momentum trading madness. Momentum trading can also involve using various short strategies to profit from market downturns.

In a sense, this kind of trading is that simple. But of course, things can be much more difficult in practice. If it were easy, then everyone would do it.

The fact of the matter is this—the vast majority of individuals who attempt short-term trading strategies like this are not successful.

History of Momentum Trading

Momentum trading is a relatively new phenomenon. This kind of trading style has been made much more readily accessible with modern technology that makes trading easier in general.

An investor named Richard Driehaus has sometimes been referred to as “the father of momentum trading.” His strategy was at odds with the old stock market mantra of “buy low, sell high.”

Driehaus theorized that more money could be made by buying high and then selling at even higher prices. This idea aligns with the overarching theme of following a trend.

During the late 2000s as computers got faster, many different varieties of this type of trading began to spring up. Some of them were driven by computer models, sometimes trading on very small timeframes.

High-frequency trading algorithms, for example, can execute hundreds of trades per second. With this type of trading, humans don’t actually do anything beyond managing the system. It’s believed that about 90% of all trades that occur on Wall Street today are executed by high-frequency trading bots.

Momentum trading has become more popular in recent years with the advent of digital brokerage accounts. There have also been a number of new investment vehicles created that are well-suited to this style of trading, such as certain exchange-traded funds (ETFs).

Ever since the widespread elimination of many commission fees back in Q4 2019, it’s possible that even more retail investors might be inclined to try their hand at momentum trading. Transaction costs and brokerage fees were also a very big disadvantage for short-term traders, as the fees could reduce profits by a wide margin.

Why are some people interested in this kind of trading? The answer is simple.

While the risks are high, so are the potential rewards.

How Momentum Trading Works

In essence, momentum trading involves picking a security (such as a stock or ETF), identifying a trend, and then executing a plan to capitalize on the trend based on the assumption that it will continue in the near-term.

There are many things that can be taken into consideration to this end. Among these are factors like volatility, volume, time, and technical indicators.

Volatility

Volatility refers to the size and frequency of price changes in a particular asset. Short-term traders tend to like volatility because wild market swings can create opportunities for large profits in short amounts of time. Of course, volatility also increases risk. In fact, one of the biggest indications that an asset has high risk is often that it has high volatility.

Recommended: Understanding Stock Volatility

Volume

Volume represents the quantity of units of a particular asset being sold and bought during a certain period (e.g., the number of shares of a stock or ETF). Traders need assets with adequate volume to keep their trades profitable. Without enough volume, traders can fall victim to something known as slippage.

Slippage occurs when there aren’t enough shares being sold at a trader’s price point to fulfill the order all at once. A trade then winds up being executed across multiple orders, each of them being slightly lower than the last, resulting in a smaller profit overall. When volume is high enough, this won’t happen, as most orders can be filled all at once at a single price point.

Time Frame

Having a plan is part of what separates successful traders from unsuccessful ones. As discussed, momentum trading usually takes place on a short time-frame, although not always as short as some day trading strategies. While day traders might hold a position for hours or even minutes, momentum traders might hold positions for a day, several days, or longer.

Technical Indicators

Technical analysis is the art of trying to predict future price movements by analyzing charts. Charting software provides traders with a long list of tools that use different mathematical formulas to indicate how the price of an asset has performed in a specific timeframe. These tools are referred to as technical indicators.

Based on one or more of these indicators, traders try to infer what the near future holds for a security. This process is far from perfect, and technical analysis might best be described as only slightly predictive. Still, it’s an important part of a short-term trader’s arsenal. What do these indicators look like?

One of the simplest technical indicators is called the Relative Strength Index (RSI). This indicator is supposed to chart the recent strength of a stock based on closing prices during a given period.

The RSI provides a simple numerical value on a scale from 0–100. The higher the value, the more overbought a security might be, while a lower value indicates a security might be oversold. In other words, a low RSI can be a buy signal, while a high RSI can be a sell signal.

The topic of technical analysis goes far beyond the scope of what can be covered here in this article. For a more detailed look at the subject, take a look at this SoFi resource.

Advantages of Momentum Trading

The main advantage of momentum trading is that it can be profitable in a relatively short amount of time when executed correctly and consistently.

Whereas buy-and-hold investors tend to wait months, years, or even decades before seeing significant profits, successful momentum traders have the potential to turn out profits on a weekly or daily basis.

While investing for the long-term requires a good understanding of the fundamental factors that go into each investment, momentum trading tends to be focused around technical analysis of charts.

While this method of trying to predict price movements is by no means infallible, it does keep things simple. Traders are focused through a single lens rather than trying to comprehend the bigger picture.

In this sense, momentum trading may be simpler. But compared to long-term investing, short-term trading involves a lot more buying and selling, and that creates additional opportunities to make mistakes.

Disadvantages of Momentum Trading

As mentioned, there are a lot of risks involved in momentum trading. Momentum traders try to make inferences about future price movement based on the recent actions of other market participants. This can work, but it can also be thrown off balance completely by a single press release or fundamental development.

For example, imagine a momentum trader identifies a strong upward trend in a stock of a telecommunications company we will call Company A.

This imaginary trader develops a plan and begins executing it, placing a buy order at a select price point when the stock dips. The plan is to sell once the stock reaches a long-term resistance level that was established months ago, let’s say.

Our hypothetical trader has done this same trade before many times and made a nice profit each time, so she thinks this time will be no different.

But then something unexpected happens. The next trading day, when profits were to be booked on a continued rising price trend, a rival telecommunications company, Company B, issues a press release.

Company B has pulled ahead of Company A, implementing a new technology that will benefit customers greatly. As a result, investors begin selling stock in company A, expecting them to lose customers to competitors like Company B.

In this imaginary case, any trends that might have been identified using technical analysis would have been invalidated quickly. Hypothetical scenarios like this play out every day in the real markets.

Tax Implications to Know

Those interested in momentum trading or other short-term trading strategies may want to review the tax implications associated with this style of trading. It can be worth reviewing how taxes will impact an investor, since they could take a chunk of an investor’s profits.

Know that the IRS makes a distinction between traders and investors, for tax purposes, and it’s important to understand where you fall. A trader is someone considered by law to be in the investment business while an investor is someone buying and selling securities for personal gain.

The IRS also differentiations between short-term and long-term investments when evaluating capital gains and losses. In general, long-term investments are those held for a year or more, while those held for less than a year are considered short-term investments. Long-term investments may benefit from a lower tax rate, while short-term capital gains are taxed at the same rate as ordinary income.

Another rule worth understanding is the wash sale rule . While some capital losses can be taken as a tax deduction, there are certain regulations in place to stop investors from taking advantage of this benefit. The wash sale rule restricts investors from benefiting from selling a security at a loss and then buying a substantially identical security within 30 days. A wash sale occurs if you sell a security and then your spouse or a corporation under our control buys a similar security within the 30 day period following the sale.

Investing With SoFi

Now you have some answers to the question, “what is momentum trading?”

In short, it involves a combination of techniques that attempt to predict and take advantage of short-term market fluctuations. This skill is hard to master, requires a lot of knowledge and experience, and carries high risk. This kind of trading is not for everyone.

No matter what kind of trading you’re into, the SoFi Invest® provides all the tools needed to get started.

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The information provided is not meant to provide investment or financial advice. Investment decisions should be based on an individual’s specific financial needs, goals and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . The umbrella term “SoFi Invest” refers to the three investment and trading platforms operated by Social Finance, LLC and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.

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Individual investors have access to a wide variety of investments in and outside of the US, which include international and domestic assets. Global investing involves investing in securities that originate all around the world.

According to Charles Schwab , global allocation provides diversification benefits and is the pillar of wealth management. It can also help investors position your portfolio for long-term growth.

Increased geographic diversification may also offer some downside risk mitigation, as the relative performance of US vs. international stocks has historically alternated, according to Morgan Stanley.

Essentially, the US markets may have a different rhythm than international markets. Therefore, investing in both has the potential to give investors the best of both worlds if one rises while the other falls, helping minimize return losses.

Investing in Global Investments

There are several ways investors can get started in the global market. But before an investment decision is made, it’s important to learn as much as possible about each investment option and understand the risks involved.

Mutual Funds

A mutual fund is a type of security that pools money collected from investors and invests in different assets such as stocks and bonds. The portfolio of a mutual fund is made up of the combination of holdings selected. US-registered mutual funds may invest in international securities. These types of mutual funds include:

•  Global funds that invest primarily in non-US companies, but can invest in domestic companies as well.
•  International funds that invest in non-US companies.
•  Regional or country funds that primarily invest in a specific country or region.
•  International index funds designed to track the returns of an international index or another foreign market.

US-registered mutual funds are composed of a variety of different international investments. As with any mutual fund, when an investor purchases a US-registered mutual fund, they’re buying a fraction of all of the securities, which increases diversification.

For investors to create this level of diversification on their own with individual stocks and bonds would be difficult, expensive, and time-consuming. Therefore, buying shares of US-registered mutual funds may give investors access to more diversification.

Exchange-Traded Funds (ETFs)

An ETF is an investment fund that pools different types of assets such as stocks and bonds and divides ownership into shares. Most ETFs track a particular index that measures some segment of the market.

This is important to understand—the ETF is simply the suitcase that packs investments together. When investing in an ETF, investors are exposed to the underlying investment.

ETFs that are US registered include foreign markets in their tracking but trade on US stock exchanges These types of investments may offer similar benefits as US-registered mutual funds.

Stocks

While many non-US companies use ADRs to trade their stock, other non-US companies may list stock directly on a US market, known as US Trade foreign stocks. For example, Candian stocks are listed on Canadian markets and are also listed on US markets instead of using ADRs.


💡 Quick Tip: Investment fees are assessed in different ways, including trading costs, account management fees, and possibly broker commissions. When you set up an investment account, be sure to get the exact breakdown of your “all-in costs” so you know what you’re paying.

Why Invest in Global Markets?

While some of these investments may seem confusing, there are a few reasons why investors might choose global investments.

Diversification

Again, choosing global investments can diversify an investor’s portfolio. It may be tempting for an investor to concentrate money in a few familiar sectors or in companies for which there is a personal affinity. But putting all their eggs in one basket could potentially lead to vulnerability.

There is no guarantee against the possibility of loss completely—after all, risk is inherent in investing. But spreading assets to international and domestic equities may reduce an investor’s vulnerability because their money is distributed across areas that aren’t likely to react in the same way to the same occurrence.

Global Growth

Another reason investors might choose to invest globally is because of the growth potential. The US is considered a mature market and may not have as much growth potential as other economies. Choosing global investments allows investors to potentially capitalize on profits from growing economies, particularly in emerging markets.

Greater Selection

If you choose not to invest outside of the US, you are narrowing your investment opportunity set. Even though investment information may be more challenging to obtain and analyze, there is the potential for a great deal of growth.

The Risks of Global Investments

As with any financial decision, careful consideration is required when selecting an investment. But, there are a few unique global investment risks and issues that need to be accounted for before investing in any global investment.

Currency and Liquidity Risk

Currency risk is also known as exchange-rate risk. It stems from the price differences when comparing one currency to another. When the exchange rate between the US dollar and a foreign currency fluctuates, the return on that foreign investment may fluctuate as well. It’s possible that a non-US investment might increase its value in its home market but may decrease in value in the US because of exchange rates.

In addition to the risk of exchange rates, some countries may restrict or limit the movement of money out of certain foreign investments. Conversely, some countries may limit the amount or type of international investment an investor can purchase. This could prevent investors from buying and selling these assets as desired.

Instability

Countries in the midst of transition, war, or economic uncertainty may also be experiencing adverse economic effects, and companies within those countries may be impacted. These days, news can change by the minute, and it might be difficult to keep on top of what’s happening when so much news is happening all at once.

Cost

Sometimes it can be more expensive to invest in non-US investments than investing domestically. This is due to possible foreign taxes on dividends earned outside the US, as well as transaction costs, brokers’ commissions, and currency conversions.

Limited Access to Information

Different countries may have various jurisdictions that require foreign businesses to provide different information than the information required of US companies. Also, the frequency of disclosures required, standards, and the nature of the information may vary from what you would see in the US.

For example, the Securities and Exchange Commission or SEC is responsible for protecting investors, maintaining fair, orderly, and efficient markets, and facilitating capital formation in the US. The SEC does this by requiring public companies to disclose “meaningful financial and other information to the public.” This allows investors to make informed investment decisions about particular securities.

Whereas in other countries they may have different organizations and guidelines for monitoring and regulating capital markets.

Additionally, analyzing individual investments is challenging enough with all the information available. But when investing internationally, the analysis adds another layer of complexity, since investors need to figure out different issues such as account, language, customs, and currency.


💡 Quick Tip: How to manage potential risk factors in a self directed investment account? Doing your research and employing strategies like dollar-cost averaging and diversification may help mitigate financial risk when trading stocks.

Consider Investment Risk When Building Your Portfolio

Risks are a part of life. It’s difficult to grow, change, or improve without taking chances. What’s safe isn’t always what’s best, so getting the best of something typically involves some risk.

When creating an investment portfolio, determining risk tolerance, which ranges from conservative investments (low risk) to aggressive investments (high risk), is a typical first place to begin.

Higher-risk investments may have the potential for higher returns, but they also have greater potential for losses. Therefore, by assessing your risk tolerance, you won’t take risks that you can’t afford to take.

Just like in life, there are no guarantees when taking an investment risk, but considering informed risks—based on research and experience—may put financial goals within reach.

Becoming a Global Investor

Even though the world’s political, economic, and sociological landscape is ever changing, considering investments in global markets may help minimize risk exposure.

To become an international investor, a good place to start might be by adding certain mutual funds and ETFs to an investment portfolio. Newer investors might be more comfortable starting with US stocks.

Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).

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