Momentum Trading: Don't Blame All Market Volatility on Daytraders

Excuse me as I climb on my soapbox. Don't worry, I won't give you a lecture, but before I tell you any more about the details of my life as a daytrader, I have to address the critics. They say momentum trading is just a passing fad. They're wrong! They don't understand. Love us or hate us, momentum traders are here to stay. Why? Because momentum is in the market, and it's bigger than all of us.

How can I say this with such confidence? Let me explain. Whenever something volatile happens in the market, experts accuse the daytraders. It's easy to say that all the volatility is caused by daytraders. Most investors don't understand where momentum comes from, and when they see something really moving, they assume it's daytraders.

As a daytrader, it is imperative for me to understand where the momentum a stock is showing comes from before I decide to buy. The way a stock reacts to momentum depends on who's causing that momentum. There are many causes of momentum, but the three main groups of momentum-makers are institutions, daytraders and individual investors.

Institutions can cause momentum for several days, or even weeks, all by themselves. I watch the size of trades, looking for big block trades in individual sectors. If I notice institutions ganging up on a sector, I will concentrate on that sector. I listen to CNBC, looking for similarities between what analysts and money managers are saying. If enough analysts and money managers gang up on a sector, it can create huge momentum. I pick the leading stock in that sector, use it as a "indicator" and play the stocks that follow its lead.

I won't argue -- we daytraders create our own type of momentum. I always set top priority on cheaper stocks, unless I'm seeing big moves from the more expensive stocks. I watch how stocks are reacting to news in the short term and how strong the bounces are at the tops and bottoms of intraday oscillations. We daytraders run in cycles; we come and go with the tide. At times I will go into buying frenzies. When this happens I hold a bit longer, but other times I sell quickly at the first sign of weakness and have to fight for every quarter-point.

So how do you know if little ol' me, the daytrader, is causing momentum? If stocks react heavily to news or the intraday bounces are strong, this indicates heavy daytrading interest. I personally want 20% swings in one day, and am looking for 3/4 to 1 point of upside potential or I will not play it.

So when institutions and daytraders are not causing momentum, then who is? Over the last few years, we have seen the entrance of a brand-new element: online traders.

There is a hidden brigade of thousands and thousands of online traders -- the moms and pops, the doctors and lawyers who have historically held for the long term. But now they're slowly turning into momentum investors. With the recent rise of Internet and other highflying stocks, they've seen others make tremendous gains very, very quickly and they want a part of them.

A look at the chart for Qualcomm (QCOM Quote) illustrates what is turning individual investors into momentum traders. In the past 12 months, the stock rose from a split-adjusted 7 1/2 to 200. Stocks like these have created a quick-sell mentality. Recently The New York Times reported that investors hold Nasdaq stocks for an average of only five months. Ten years ago, they held a stock an average of two years. If someone offers you 10 or 20 times the value of your car, would you sell? Of course you would.

A good majority of individual investors now trade on as well as create huge momentum in the market. Individual investors are apt to do anything: move into a stock with absolutely no earnings or no reasonable price-to-earnings ratio, toss fundamentals aside. Take a look at the fundamentals of Amazon.com (AMZN Quote) if you need proof.

These individual momentum investors no longer follow the large brokers; they make their own decisions with information and data available instantly online. When these investors jump on a stock, so do daytraders.

A good example of this is the recent action in fuel-cell stocks. Fuel cells have an environmentally friendly method of generating power electrochemically from energy sources such as hydrogen and have been touted as the replacements for everything from flashlights to automobile engines. Last month, they were hot. Momentum investors jumped aboard stocks like Plug Power (PLUG Quote), creating momentum that caused a rise in the share price from 26 to 155 in less than a month.

Last Monday after a 50% retracement, I played a pullback oscillation at around 76 1/2. Two days later, the stock closed at 113 7/16.

Guess who was blamed for the volatility in this sector? Daytraders, of course! In fact, most of the momentum was caused by individual investors latching onto an exciting story.

These momentum-loving individual investors differ from daytraders, though, in that they buy and hold, waiting out the short-term oscillations. Daytraders take advantage of these swings, capturing more of the potential. I normally end the day in cash, which reduces risk. I won't ride a bad market out.

Bottom line is, even if you get rid of every daytrader out there, you will still have huge momentum in the market and as long as there is momentum in the market, you will have momentum traders, and the numbers are growing rapidly. I get asked all the time by physicians, attorneys, engineers and housewives how they can take profit from the phenomenal gains that the market is showing. The dynamics of the market have forever changed. Those who can't recognize this new type of momentum and adapt their methods are destined to be left behind.

Now, I've finished my sermon for the day. That wasn't so bad, was it? I only fell off the soapbox twice and got three splinters. Next week, I'll tell you about a few other falls I've had when we talk about why daytraders lose.