What is “Momentum Investing”?
Momentum investing is an investment strategy that aims to benefit from the continuance of an existing market trend. A momentum investor would typically buy securities whose prices have been rising (upward trend) or short-sell securities whose prices have been declining (downward trend). The main idea behind these trades is that once a trend is well-established, it is likely to continue. Investors can benefit by staying with a trend until its conclusion. Momentum investing requires a solid analysis of technical indicators which can serve as a guide on when to enter or exit a particular position.
Key Learning Points
- Momentum investing is a strategy that relies upon technical analysis as a guide to make investment decisions
- Its philosophy is based on profiting from the continuance of existing market trends
- Momentum investors believe that well-established market trends are likely to continue their direction
- Some of the most popular indicators that momentum investors use are moving averages, trend lines, and oscillators
Understanding Momentum Investing
Unlike value investors, who try to establish the intrinsic (or fair) value of security through fundamental ‘bottom-up’ analysis, momentum investing typically requires following a set of rules based on technical analysis that guide the buy and sell process. This strategy is very popular with traders who seek to benefit from either buying or short-selling securities when they exhibit strong trends. It is typically targeted at short-term investors such as traders as they are trying to capture the price movement in a trend. In addition, when momentum is high, markets also tend to show higher levels of volatility.
Tools That Traders Use For Momentum Investing
1. Moving Averages
They help traders to focus on the broader picture of prevailing market trends while limiting the short-term “noise” that comes as a result of small price movements. Upward trends are indicated by the security’s price being consistently above a moving average, while a downtrend is normally detected by the price keeping at or below a specific moving average.
2. Trend Lines
This is a basic tool used for monitoring price movements. A trend line is typically drawn between two successive points on a price chart. A buy signal would be indicated by the resulting line sloping upwards, where a downsloping line would signal a negative trend and potential opportunity to profit from short-selling.
3. Stochastic oscillators
This tool is used to compare the security’s closing price to a range of prices over a predetermined period. Should that be near the high of the price range for the predetermined period, then the trend is positive. On the other hand, if the price is near the low then the trend is negative. The stochastic oscillator values range from 0 to 100, where values above 50 show a strengthening uptrend and values below 50 indicate a downtrend.
Another important feature of oscillators is that they show when security is overbought or oversold. For example, a reading below 20 indicates oversold conditions that could result in a market reversal. On the other hand, values above 80 indicate overbought conditions and a potential negative reversal.