Momentum vs Trend Trading: Which is More Profitable?
By: Steve Smith
I have a hard time buying new highs as I prefer to buy pullbacks at support levels. But I also want to get long stocks that are trending upward, or short those trending down. So, how do I make sure not miss out on stocks while waiting for a pullback? Honestly, it’s hard and I’m still learning.
Something I have more difficulty doing is getting momentum stocks in which, by definition, you are almost always buying new highs. In fact, a new high might be required to trigger the trade.
So what’s the difference between momentum and trend trading?
Momentum trading is generally used to capture strong moves in short time frames, usually for not more than a few hours or a few days. Generally, momentum traders are very focused on only a few trades at a time — at most — and scan a large watch list for a few signals.
Trend followers, by contrast, manage portfolios for entries and exits across diversified assets (usually future contracts), reacting to signals that allow them to capture the profits in long-term trends and be on the right side of rare outlier events that lead to large profits — through huge parabolic moves in one direction over a longer time period.
Momentum is the acceleration in a stock’s price that can be due to earnings, sentiment, news, greed, or fear. Momentum traders will take a long or short position in the stock. The hope that its momentum will continue in either an upward, or downward direction in the time frame they are trading.
This strategy relies on short-term movements in a stock’s price rather than long-term fundamental valuations. Momentum traders are trying to capture a strong move based on aggressive buyers or sellers bidding a price up or down by overwhelming one side of the bid/ask spread and setting off a strong move in one direction usually temporarily for hours or days.
Square (SQ) has been a major momentum stock, turning nearly parabolic until today’s pullback.
Trend following trading is reactive by nature. It does not forecast or predict markets or price levels. Prediction is impossible. Trend trading demands self-discipline to follow precise rules (no guessing or wild emotions). It involves a risk management system that uses current market price, the equity level in your account and current market volatility.
One will usually ride the overall trend for as long as it stays in place and use pullbacks to support add to the position and rallies to resistance to reap profits.
Adobe (ADBE) has been in a major uptrend for most the past year. But, it has had notable multi-day pullbacks towards the 50 DMA which have proved to be good buying opportunities.
Trend traders use an initial risk rule that determines position size at the time of entry. This means you know exactly how much to buy or sell based on how much money you have. Changes in price may lead to a gradual reduction or increase of your initial trade. On the other hand, adverse price movements may lead to an exit for your entire trade.
Historically, A trend trader’s average profit per trade is significantly higher than the average loss per trade.
Trend trading is not a Holy Grail. It is not a passing fad or hyped-up secret black box either. Beyond mere rules, the human element is core. It takes discipline and emotional control to stick with trend trading through inevitable market ups and downs. Trend following seeks to capture the majority of a market trend, up or down, for profit. It aims for huge profits in all major asset classes — stocks, ETFs, LEAP options, bonds, currencies, futures, and commodities.
Think of it this way: trend following is the only strategy that you could trade on a desert island. As long as you have market data each day, everything else is useless.
Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.
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