This explainer discusses what momentum means in stock trading, the meaning and methods of momentum trading, and its benefits and drawbacks.
In the stock market, momentum refers to the sustained increase or decrease in the price of an asset. The direction or trend followed by the price of the asset for a prolonged period of time, whether increasing or decreasing, is analysed by some investors to place their trades and make maximum gains.
In technical terms, momentum in stocks is a measure of the velocity at which the price of an asset changes. This is in opposition to the actual price levels. The momentum of a particular stock's price can be computed by measuring the price difference for a given time period continually.
For instance, to calculate the momentum over 15 days, the closing price of the asset from 15 days ago will have to be subtracted from the latest closing price. This can be depicted on a graph by plotting the result around the zero line. If prices are moving upwards, they will be seen above the zero line, and those moving downwards will be depicted below it.
How momentum in stocks works
As an indicator, price momentum is an unbound oscillator. This means when the price momentum of an asset is plotted on a graph, there are no upper or lower boundaries. These levels are drawn manually along the upper and lower limits after all the fluctuations are represented on the chart. When the asset is overbought, the indicator tends to move higher and when it is oversold, it is lower.
Momentum trading or investing is a strategy used by investors to make use of the oscillations in the price of an asset in order to make the most gains. Usually, such trading diverts away from the norm of buying underpriced assets low and selling them when they gain in value. Instead, the focus is on buying quality stocks or other assets at a higher price and then selling them even higher.
Momentum investors read the indicator graph somewhat like this—
- When the price of an asset breaches the zero line in an upward trend, they would buy the asset in question.
- If the price dips below the zero line in a downtrend, investors would sell short.
- If the prices reach a new high or low that the momentum indicator cannot confirm, it may be an indication of a reversal in the price.
- Momentum investors try to understand the broader picture by using these indicators to trade in the direction that the overall trend has taken.
Methods of momentum investing
Momentum investing assumes that upward and downward trends can stay for a significant period of time. The goal is to profit from these trends by sticking to them irrespective of the time they take. When the prices are in an upward trend, momentum investors go long on stocks, ETFs, futures or other securities. In times of a downward trend, they go short. Here’s a look at some of the methods adopted by momentum traders to learn to trade momentum stocks—
- Two moving averages over the longer term, where one is slightly shorter than the other are used for trading signals. For instance, when a 70-day average crosses over a 200-day average, investors buy and if the shorter one dips below the longer one again, the indication is to sell.
- Another strategy used by momentum investors is to use price-based indicators to go long on sector ETFs when the momentum is at its strongest and going short on these securities with the weakest momentum. They eventually rotate in and out of sectors accordingly.
- Other methods are a combination of momentum trading and fundamental factors such as earnings per share (EPS).
Benefits and drawbacks
Risks and rewards go hand in hand for investors in the momentum stock market. This holds true of momentum trading as well. Here are some of the advantages and disadvantages unique to momentum trading in the stock market—
There is a potential for high profits over a short duration of time with momentum trading.
Momentum investors often struggle with the high fees as the stock turnover is also substantial.
Instead of giving in to emotional responses to stock prices, momentum investors leverage the shifts in stock prices that arise because of emotional investors.
Such an investment strategy is sensitive to the market as it works best in a bullish market when investors tend to have a herd mentality. In a bear market, the profit margins shrink as investors are more cautious.
Momentum investors can take the volatility of the market in their stride and take advantage of maximising their returns on investment.
Momentum investing is also extremely time-sensitive and requires investors to monitor the market daily, if not more frequently.
The momentum anomaly
Momentum in the price of an asset is widely considered to be the result of an anomaly in the market. The efficient market hypothesis, an investment theory that originated from the works of Eugene Fama, states that the price of an asset is indicative of all the information readily available around it presently.
It further states that any change in the price of an asset occurs because of new information. So, the previous performance of an asset should not be reflective of its future performance. An increase in the prices of stocks now does not mean that there is a reason for them to increase in the future. As per the efficient market hypothesis, any momentum should not take place.
Some experts are of the belief that momentum occurs due to investor irrationality because according to the efficient market hypothesis, only rational behaviour governs the market. Cognitive bias, confirmation bias and other personal beliefs and behaviours of investors, therefore, give rise to momentum, they believe.
Momentum trading demands incredible discipline from investors, can be relatively less cost-effective due to the commissions payable, and steers away from the common adage “buy low, sell high”. While these factors make it averse to many traders, a surge in low-cost brokerage services has helped remedy these problems. Once traders and investors identify if such a strategy is in keeping with their investment goals and learn to trade momentum stocks, this strategy can bear fruit and reward investors.
How do you find the momentum of a stock?
The momentum of a stock is measured by taking the price differences continuously over a fixed period of time. A 10-day momentum can be measured by subtracting the closing price from 10 days ago from the last closing price.
What is a high momentum stock?
High momentum stocks refer to the stocks the prices of which can rise quickly over a short period of time. However, such stocks are risky and can crash in an unexpected fashion.
How is momentum used in trading?
Momentum traders take advantage of market volatility by taking short-term positions for stocks that are rising. These are sold as soon as they start showing signs of falling.