Learning about momentum in physics may not help you earn money unless you want to become an engineer or scientist. Still, in investing, momentum can help you beat market averages and increase profit percentage if done correctly.
Yes, we are talking about momentum investing, which most successful investors practice. What it is, how it works, and the risks involved, this article will discuss all you must know about momentum investing.
What is Momentum Investing?
It’s an investing and trading strategy to invest in stocks based on recent market trends. For example, if the stock’s momentum is showing an upward trend, you purchase the stock, and if it is in a downtrend, you short-sell the stock. The investment duration depends on how long the trend continues.
The rationale behind momentum investing is that once the trend is established, it is likely to continue. In momentum investing, stock investment is based on technical analysis, and the rules of fundamental analysis don’t apply.
How does Momentum Investing Work?
The common cause of momentum in any stock is the market’s herd behaviour. Two emotions cause herd behavior – fear and greed that constantly battle for dominance in the market. Momentum investing is mostly about playing on these two emotions to profit from them.
In any stock, investors’ reaction to initial price action is often slow, but once a definite trend is established, more investors follow up, driving up the momentum. It is a short-term investment strategy that plays out over 3-12 months.
Different Types of Momentum Indicators
There are many ways to select momentum investing stocks, but the most common way to do so is by choosing the stocks that are gaining or losing for the past 3-6 months. The next step to implementing a momentum investing strategy is using momentum indicators to measure the strength of stock movements.
Here are some of the popular momentum indicators to use:
It is a basic charting tool where you connect two extremely consecutive price points using a straight line. The trendline should have at least three touchpoints, not cutting through the candlesticks. Refer to the chart below to how it is drawn.
If the resultant line is an upward slope line, it suggests a bullish trend, and the likelihood of investors buying the stock is the highest. On the other hand, if the line slopes downward, it’s a bearish trend.
The lines act as a support and resistance for the stock and witness maximum price action around those lines. Therefore, one can extend the trend into the future to ascertain the support and resistance levels and place trades accordingly.
Moving Averages is a potent charting tool and can help you to identify the trend accurately by removing the noise in the market. In addition, it helps to smoothen out the price data over a specified period and constantly update the average price.
The most common time duration used in moving averages is 50, 100, and 200 days. If the stock price continuously trades above the moving averages line, it indicates an uptrend. And, if it sells below shows general weakness in the counter.
For a longer investment duration, you must track the moving average for a longer time as they are less sensitive to recent price changes.
Relative Strength Index (RSI)
If you are unsure about the strength of the momentum in the stock price, RSI will help you to measure it. The RSI oscillates between zero and hundred (0-100). Usually, when the RSI slope is below 30, the stock is considered oversold, and above 70 is considered overbought.
Generally, when the RSI is oversold, it is considered the best time to buy; when overbought, investors usually sell the stock. However, you must note that during strong trends, the RSI may continue to remain in the overbought and oversold territory for a longer duration.
In an uptrend market, the RSI tends to hover between 40-90 levels, and during a strong downtrend, it stays below 20. If you witness a stock price making a new higher high, but RSI is making lower highs, it indicates an ebbing of the momentum and vice versa.
Moving Average Convergence Divergence (MACD)
Moving Average Convergence Divergence (MACD) showcases the relationship between two moving averages, 26 and 12 EMA, to generate buy and sell calls based on the momentum of the stocks.
*EMA= Exponential Moving Average
In a Moving Average Convergence Divergence (MACD) chart, the MACD line is the difference between 26 and 12 EMA, and there is a signal line- 9 EMA. When the Moving Average Convergence Divergence (MACD) line cuts through the signal line from below, it generates a buy call; when it cuts from above, a sell signal is generated.
Benefits of Momentum Investing
If an investor understands the market dynamics, momentum investing can help earn huge profits. Other benefits are:
● less time spent doing a technical study as compared to fundamental research.
● using the market volatility to own advantage
● capitalizing on emotional decisions and herd instinct of other investors
If done rightly, momentum investing can help you beat the average market returns; however, you must initiate any trade after thorough technical research. Moreover, do not ignore the risks involved, like higher volatility, which can instantly make your trade go wrong. Furthermore, momentum investing is time and market sensitive, which requires you to track the market regularly.
The question is, does momentum investing help you create wealth? Unless you track the market continuously, sell at the right time and buy at the right time, earning high returns is impossible.
Moreover, the market is unpredictable, which makes timing the market difficult. But if you want to create wealth, then the best thing you can do is invest for the long term. Build a solid well-diversified portfolio and let your investments grow.
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Disclaimer Note: The securities quoted, if any are for illustration only and are not recommendatory.