If you've ever been bowling, you'll know that feeling of watching your bowling ball rolling down the alley and straight into . . . the gutter! Balls are heavy, and when they head down the lane, they are supposed to kick over ten pins. But sometimes they don't get there! Sometime the ball will actually speed up as it heads down the lane, that is gain momentum. You may remember the formula that your physics teacher gave you:
Momentum = Mass x Velocity
That's why Investopedia describes Momentum by reminding us that "price is more likely to keep moving in the same direction than to change directions." 
That is, until it loses momentum and slows down. Many stocks go through periods of high momentum and then settle back to normal. So we look for momentum plays rather than momentum stocks.
Our tools for trading are options with high Delta (.7 to 1.0 for calls, -.7 to -1 for puts) which provide similar results to own or shorting the underlying stock--but with much less risk.
Identifying Momentum Plays
Momentum is not the same as trend. There are many stocks which have nice trends, but they aren't moving very much each week. We need to see big moment in a short period of time! In a momentum options play, we make money not so much from decaying time premium (Theta), or from a change in volatility (Vega), but from price movement. Momentum stock charts usually show longer candles, strong directional trends, and gaps in the chart.
Take a look at these charts of PCLN and NFLX, 
each of which shows periods of strong momentum. The first PCLN chart covers a longer period, showing many gaps in the chart, which are accompanies by long candlesticks.
The second shows recent momentum moves by NFLX: a large gap 
up and sustained run, followed by a reversal with price in the process of turning down. Notice how the price just crossed the 30-day moving average (red line) on its way down. That's UP momentum followed by DOWN momentum (or DOWN followed by UP) which combine to make a reversal.
Stocks which move strongly up or down are often the victims of changes in sentiment. Investors feel bullish and then the stock feels overbought, or reaches a technical resistance area on the chart, and sells off. After viewing many charts, I've concluded that the be
st momentum stocks have a "fan base" (such as AAPL, TSLA, WYNN) and show wide swings in price. The stock swings between being overbought and oversold. But any of these may not be in momentum right now! You still need to follow the signs that momentum has struck.
Finding Momentum Stocks and Plays
A stock can be in high momentum at any time, but usually the following rules apply:
- the higher the VIX, the more stocks are moving
- the higher the volume, the more stocks are moving
- momentum often follows a reversal of direction
- earnings announcements often jolt stocks into momentum
- expiration week usually attracts large moves
Some of my favorite momentum stocks are PCLN, NFLX. AAPL and AMZN. They sometimes show all the right features and their charts are easy to interpret. One way to find the plays is to scan each day for high ATR stocks, or stocks which are moving more than 1% per day. You can simply ask for stocks which have jumped more than $5 or which have left a gap in the chart. Another way is to scan by Volume, as high volume up or down usually indicates large price movement (but not always). Big price movement on its own is not enough evidence, as a stock might go up $10 one day and then down $10 the next. Look for preceding bottoming and topping patterns such as in the NFLX example above.
Tools for Finding Momentum Stocks
Short-Term Momentum: All traders should know how to use the thinkorswim Scan tool. It will help you find stocks which are moving more than the general market on any day. You can adjust the "% Change" function to suit market conditions.Here we asked the Scan for any stocks between $100 and $200 that moved over 2% last trading day, which produced 29 results, listed from greatest change to least. (Notice the columns used: Last, Net Change, Beta, ATR, Volume).
We can also ask for stocks which dropped more than 2%, getting six results.
Of course, not all these would be automatically classed as momentum stocks. A little research is needed, including looking at the news which produced the change, the volume, and some chart analysis. In general, stocks with wider ranges tend to oscillate regularly, and might frequently be in momentum.
Long-term Momentum: Many traders use a screening tool such as FinViz (Financial Visualizer) to find stocks based on selected criteria. To find momentum stocks, you would perhaps use these:
- Forward PE: Over 50
- Price/Book: Over 10
- Sales Growth Q/Q: >15%
- EPS Growth Next year: >15%
- EPS Growth Next 5 years: >15%
- Sales Growth Past 5 years: >15%
- Float Short: >10%
This screen will tend to select for stocks which are in longer term momentum, and are bullish. Appropriate strategies for these kinds of momentum trades would be Bull Put Spreads, including deep-in-the-money spreads.
But before you jump in and trade just any stock that might be having a good day, take a moment. Does this stock have a history of momentum? How much is the usual large move? Are there confirming signs such as charts gaps or large candlesticks up or down? Finally, ask yourself, what is the best strategy for this momentum stock?
Choosing Momentum Strategies
So what option tools will you use? You would choose directional strategies, and you have a few choices:
1. Buy or short the stock? You risk is limited to your total investment, although it rarely happens that traders lose everything on a single trade.
2. Buy a Put or Call? Remember that options can be used to substitute for stock. We prefer to use In-the Money options, with a Delta of at least .7 (or -.7 for a Put) and preferably above .9 (or -.9 for a Put), as these options closely mimic stock behavior. Remember that the higher the Delta, the deeper ITM it is, and also the more expensive. Your risk, of course, is limited to the cost of the option, which should be much cheaper than the price of the stock.
Although in our HOT Trading System we usually sell rather than buy options, the momentum trade can be an exception, because time decay is not likely to be a significant factor in the option price. The most risk is in buying OTM Puts and Calls, which frequently expire worthless. Even options bought ATM are not usually a good strategy for more than a few days, as time decay begins to erase value.
3. Sell a credit spread. An OTM credit spread should be placed at support, and far enough away from the current price. Your risk is limited to the difference between the strikes minus the credit you receive. An ITM credit spread should be deep enough to ensure that the sold leg (your money-making leg) will have a Delta of at least .9 (or -.9 for a Put) Instead of buying a Put, some traders sell DITM Calls. For all credit option cases, you should expect the price to move away from the bought or sold strike. The main advantage is that you aren't fighting against time decay.
4. Buy a debit spread. By buying one leg and selling another, you reduce your overall cost or risk, but you also limit your profit. These are best used for short term plays, where you expect a limited move. However, if that is your strategy, why not buy a Call, then later sell a Call to bring in as much money as the first Call. Your net cost will zero or better, and so your loss is also zero.
5. Momentum Day Trade. As a general rule, stocks which open significantly down (from yesterday's close) will continue down until they found support. The opposite is also true: stocks which open higher will continue up for a while. This regularity can be traded for profit
This is even more true for indices such as the SPY, RUT or QQQ, as these momentum moves are supported by higher volume across a range of stocks. Using Long Put or Call options, purchase an ITM option and close using stop-limit orders to protect your profit. This strategy is also effective with stocks exhibiting a beta of 1.0-1.5.
As for other strategies, a long straddle or strangle might be profitable, but remember you are paying double for the strategy and the price will have to move a long way for you to be profitable. A covered call might be profitable, but the potential profit will be limited by the placement of the short Call.
Avoid non-directional strategies such as Iron Condors or short Straddles. These should be avoided, as one leg might be easily crossed in a momentum play.
Identifying Declining Momentum
Momentum declines when stocks hit resistance or support. If you examine most stocks you will usually see that they rarely advance or decline more than four or five days in a row. Very high volume usually signals that momentum has hit its maximum. Price movement can slow, or suddenly switch in the opposite direction. A change in direction is sometimes marked by a doji, as traders spend a day in indecision.
Closing a Momentum Play
If you have chosen the correct strategy, you should be profitable. Feel free to close the option or spread whenever momentum stalls or begins to reverse, or you reach your target. For long puts or calls, use a TRAILING STOP which locks in profit whenever the stock drops a set amount. Or simply add the opposite option to lock in your profit and potentially catch more profit as the stock retraces. For Credit Spreads, close when you have reached significant profit, or whenever you see the stock slowing down its movement (usually at support or resistance).
HINT: You buy a Call and the underlying stock moves up $15 in a couple of days, then buy a Put to freeze the profit. If the stock retraces $5, you made $5 on your Put to compensate for the drop in price, and still made $15 overall.
If you use long Straddles or Strangles, buy the cheapest long position available and set to sell when you have 20% profit, using a LIMIT order. Remember time is against you with these strategies, and greed will hurt you! So get in and get out again quickly--in a few days--before time decay eats away your investment.
Finally, you'll know you are a real trader when . . .
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HOMEWORK
Review
1. Read the blog carefully and follow the examples. If you got this far, you've probably done it!
Trading Practice
3. Identify 10 momentum stocks, including SPY and one or two pharmaceuticals. But we are not just looking for upward or downward trending stocks! The momentum should be based what has happened to the stock in the last 10 days, not the last year!
4. Place orders to buy a Put or Call for each, based on the direction you think the stock is moving.
5. When filled, place orders to close these where you think the stock will meet resistance or support. (Ask for help from your partner if you don't know how to find R and S on the charts.) You may also add another options if you wish, such as a short call, creating a vertical. You will need to calculate the approximate price of the option at the point of sale.
4. Try the Quiz. Why slow your momentum now?
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