As a strategy for trading in the financial market, momentum investment is focused on benefiting from continuing and persistent market trends. Typically, under this method, investors buy stocks that are on the rise and sell them when they have climbed almost to their peak, with the profits lying between the initial position and the market exit close to the peak.
Momentum investment relies on the ‘momentum’ in the market, which is the ability for price trends to persist over time.
Understanding momentum investment
Under the momentum investment method, investors in the financial market secure long positions in assets like ETFs, futures, stocks, etc., when they show an upward trend in prices. Also, short positions are taken when the price is falling.
The underlying belief of this investment method is that market trends are persistent and stick around for a while. This period can then be leveraged to enter during an upward movement and stay until the asset market value reaches its peak.
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Momentum investment methods
Momentum investment does not usually happen without a predetermined set of rules that must be strictly adhered to. To highlight potential entry and exit points in the market, these rules are based on several technical indicators:
- Momentum investors often use two long-term moving averages (MAs) for trading signals, such as 50-day and 200-day MAs. One of the two moving averages is typically longer than the other. A buy signal occurs when the 50-day MA crosses above the 200-day MA, and a sell signal occurs when it crosses back below. Do understand here that some investors in the market also utilise even longer-term MAs.
- Momentum investing strategy also involves going long on sector ETFs with the strongest momentum and shorting those with the weakest, then rotating between sectors based on price signals.
- Another momentum strategy involves cross-asset analysis. Let us assume that some investors are relying on the Treasury yield curve as a signal for buying or selling stocks. In this specific situation, assuming all other factors are constant when the 10-year yield is above the 2-year yield, it’s a buy signal; when the 2-year yield is above the 10-year, it’s a sell signal. This yield difference is crucial as it can affect stock markets and predict recessions.
- Some strategies combine momentum with fundamental factors, like the CAN SLIM system. It focuses on earnings and sales momentum, highlighting stocks with price momentum.
For momentum investment, it is vital to choose the right securities, consider liquidity and trading volume, and follow entry and exit rules based on technical analysis.
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Debate over momentum investment
These days, only a handful of professional investment managers use momentum investment. It is believed that choosing the right stocks individually based on metrics like the discounted cash flow (DCF) analysis and other fundamental factors generates more predictable results and is a better strategy for outperforming indexes in the long run.
Technical indicators that momentum traders can utilise
For traders and investors in the financial market, there are numerous momentum indicators that trend analysts can utilise. Some of the most popular methods include price rate of change, relative strength indicator, moving averages, and stochastics. Let us take a look at all these indicators and what they mean:
- Price rate of change: This indicator measures the percentage change in price over a specified period. It helps traders identify the strength of a trend by showing how quickly prices are moving up or down.
- Relative strength index (RSI): The RSI calculates how quickly and how much the price of an asset changes. Its range is between 0 and 100, and it is used to identify oversold or overbought conditions in the market. A reading above 70 indicates an overbought condition, while a reading below 30 indicates an oversold condition.
- Moving averages (MA): These are used to smooth out price data and identify trends over different time frames. Moving averages can help traders determine the direction of the trend and potential reversal points.
- Stochastics: This momentum indicator compares a security’s price range to its closing price in a given period. The Stochastic Oscillator generates values between 0 and 100 to compute overbought or oversold conditions. Readings above 80 suggest overbought conditions, while readings below 20 indicate oversold conditions.
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The formula for market momentum
The formula for market momentum is described below-
Market momentum = The latest price (or V) - Closing price from several days ago (or Vx)
Where ‘Vx’ represents the closing price ‘x’ number of days ago.
Market psychology underlying momentum trading
The herd mentality, along with emotions like fear and greed, are all vehicles to affect the price sentiment in the market. When many investors follow a trend, it can drive prices up, initially benefiting those already holding the asset. However, this can also result in a sharp decline if the stock becomes overvalued. Thus, understanding these psychological factors is crucial for navigating momentum trading successfully.
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Conclusion
Momentum investment is a strategy that takes advantage of prevailing market trends by buying rising assets and selling them near their peak. It relies on the belief that trends will continue for a while, allowing investors to profit from all price movements. The approach involves using various technical indicators, such as moving averages, price rate of change, relative strength index, and stochastics, to determine entry and exit points. By carefully selecting securities and adhering to defined rules, you can navigate the market effectively and potentially achieve significant returns.
