Momentum
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A momentum strategy involves the use of price momentum, i.e.
entering a trend at the right time, namely while the price is rising, and exiting the trend at the appropriate time, preferably before the price is falling. Consequently, investors buy securities when the price trend is upward and sell securities when the price trend levels off. It is difficult to determine when it is appropriate to enter or exit. The momentum strategy
takes advantage of the volatility, by buying during short-term uptrends. Technical analysts often use oscillators to identify trends, which measure momentum. Momentum investors
seek to profit from the herding behavior of investors. It is therefore rather difficult for an inexperienced investor to implement a momentum strategy. In contrast to the large mass of investors, it is necessary to have a high level of expertise and experience in order to recognize the right moment and avoid missing it. It may therefore be worthwhile to hire an
experienced and independent wealth manager to implement the momentum strategy. Momentum strategies involve the risks of entering a position too early, exiting too late, getting distracted, and missing important trends and technical divergences.
Momentum investors seek
returns by investing in stocks that trend upwards. The
investment focus is on trending stocks, as opposed to
value investors, who intentionally avoid trends. A stock that is in an upward trend is also referred to as a "hot stock". The
shares are measured by the price increase over a certain period of time. The term "cold stock" refers to a stock that is in a downward trend. The momentum investor takes advantage of herd behavior and market psychology, and does not follow Wall Street clichés such as "buy low, sell high". Instead, he follows the principle:
buy high, sell higher. Whenever a momentum trader observes a positive trend in a stock's price, earnings or revenues, he will buy and hold the position for as long as the positive trend persists. Contrary to
value investing, momentum investing refers to short-term price movements, usually within three to twelve months, rather than fundamental valuations.
To determine when to enter and exit, momentum investors use indicators. An example of this would be the examination of the trend line. In order to generate a trend line, it is necessary to define a time period first. In this instance, the trend line represents the line drawn between the highest and lowest price over the specific period of time. Stocks are bought by momentum investors if the line runs upward. In the case of a downward trend line, the momentum investor sells the stock. Due to this, momentum investing can be considered a technical indicator. However, momentum indicators can also refer to key performance indicators such as sales and earnings. However, historical prices are most commonly used as a technical indicator.
Please visit the post on the 125/250d Adjusted Slope for a more detailed explanation and other momentum indicators.
The following are some of the advantages of momentum investing:
- High profits can be achieved in a short period of time: Consider the case of an investor, who invests in a stock, as he expects the stock price to rise over the long term. The investor buys the share at a value of CHF 100 before other investors realize the upward trend, and the share price actually rises to CHF 130. Due to the investor's timely entry, he can now sell the share for CHF 130 and make a 30% profit.
- Talented investors manage to use volatility to their advantage.
- Good investors can get a benefit from the irrational investors: Investors who are irrational respond emotionally to information. By exploiting the volatility in prices caused by irrational investors, momentum investors can take advantage of the herd behavior.
Prices may not always develop as expected. Markets may reverse or correct unexpectedly at any time, despite intensive analysis and experience. In general, the momentum strategy has the following disadvantages:
- High share turnover can be costly, due to high transaction costs.
- Time investment: The momentum strategy requires regular monitoring of market data in order to succeed.
- Market sensitivity: The best time to implement the momentum strategy is when stock market prices continue to rise. A decrease in prices, on the other hand, will result in a reduction in profit margins since investors will become more cautious as the market declines.
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