Momentum - Definition, Use , Benefits & Drawbacks

Momentum, according to some traders, is defined as the speed of the movement in the market. However, momentum is much more than that, and we should know every dimension adhered to the term.

The term depicts the motion that an object possesses. If we understand the definition with context to stock markets, the word "object" will get replaced with stocks or the index. 

Let's explore the aspects of momentum trading in this chapter, and find out how it impacts your trading endeavours.

Momentum Strategy

This is considered as one of the most popular strategies amidst the traders. There are various ways by which traders measure momentum to identify opportunities, but the motive remains the same, that is to identify the accurate momentum and ride the wave.

The strategies are usually developed around a single-stock basis with the core idea to measure the momentum throughout the stocks in the market. The ones that show the highest momentum are the ones to trade on. Momentum, however, can be either long or short, and so can be the trading opportunities.

Momentum strategies are also developed, specifically based on sectors, to set up trades. One has to identify the sectors that possess strong momentum by keeping track of it in sector-specific indices. Once it is done, identify the stocks with maximum momentum within the sector.

Momentum is also developed on a portfolio basis. This concept is inclusive of creating a portfolio with x number of stocks. Each of the stock in this portfolio depicts momentum, and this is considered as a great strategy in terms of diversification.

How do traders implement momentum trading strategies?

The strategy begins with identifying the trend strength in a specific direction, after which the traders open a position from which they hope to gain some from the change within the asset's price. Once this happens, they close the position as the trend begins to lose its strength. Momentum traders aim to exploit the market sentiment and the herd mentality.

Use of the Momentum Indicator

Traders consider momentum unsustainable once it reaches a certain level. They then use it as a price reversal indication. There should be no use of indicators to make trade decisions, even if it is used to find price reversals, 2-3 indicators should be used to get a clearer picture.

Suppose there is the use of an indicator for say cryptocurrencies. In that case, it may not provide accurate results since the asset is highly speculative and there lie a wide range of opinions regarding their valuation. Such assets often create very erratic trading behaviour. So even if the momentum has reached an extreme level, it doesn't mean that it will retreat under it in due time. There can be many contradictions on how to use the momentum among traders and investors at the same time.

So when we talk about momentum trading, the trend is all about riding the wave to capitalize on traders' emotions. The approach around momentum trading is to "buy high and sell higher" or "sell low and sell lower".

Benefits of Momentum Investing

Momentum investing provides huge profits, only if the trader knows the hows and whys. The one who knows how to handle the risks involved can go forward with this approach.

1. Potential for more High Profits Over a Short Period: So if you start with buying a stock for INR 500 and it grows to INR 750. And then you decide to sell it further at a profit margin of 50% before the stock price changes; you made a 50% return in a period of a few weeks or months. Over time, the profit potential will increase using momentum.
2. Leveraging the Market's Volatility to Your Advantage: Momentum Investing is all about capitalizing on volatile market trends. It is all about looking for stocks that are high and then selling them before the price drops.
3. Leveraging the Emotional Decisions of Other Investors: The blog by Ben Carlson on A Wealth of Common Sense, momentum trading is explained as a chasing performance. However, there is a systematic method in which momentum investors perform that includes a specific buying point and selling point. They are not controlled by emotional responses to stock prices like many investors are, rather they seek to take extra advantage of the changes in stock prices caused by emotional investors.

Drawbacks of Momentum Investing

Everything comes with pros and cons. As they say, for every silver-lined cloud, there may also be rain. Momentum investing also includes some drawbacks. 

There is always a particular amount or percentage of risk involved if you are a momentum investor. Most momentum investors go forward, keeping in mind the risk factor involved as they look for the possibility of returns.

1. High Turnover: This can be expensive as high fees are involved. Low-cost brokers are trying to put an end to the problem of high fees, but this remains a major concern.
2. Time-Intensive: Momentum investors also have to keep track of market details regularly as the price can go up and down quite a few multiple times a day, so even if not hourly, a daily update is necessary. This means having every update to know about any negative news that will spook investors. 
3. Market Sensitive: Momentum investing is considered to work best in a bull market as the investors tend to herd a lot more. In a bear market, the margin for profit on momentum investing shrinks by increased investor caution.

Wrapping up

Now that you understand the basics of Catching a falling knife, let’s learn All About  Averages in the next two chapters. 

A Quick Recap

• Momentum is the speed or velocity of price changes in a stock, security, or tradable instrument.
• Momentum shows the rate of change in price movement over a period of time to help investors determine the strength of a trend.
• Investors use momentum to trade stocks whereby a stock can exhibit bullish momentum–the price is rising–or bearish momentum–the price is falling.