What Is Momentum?
Momentum is the rate of acceleration of a security's price—that is, the speed at which the price is changing. Momentum trading is a strategy that seeks to capitalize on momentum to enter a trend as it is picking up steam.
Simply put, momentum refers to the inertia of a price trend to continue either rising or falling for a particular length of time, usually taking into account both price and volume information. In technical analysis, momentum is often measured via an oscillator and is used to help identify trends.
Key Takeaways
- Momentum, finance, refers to the capacity for a price trend to sustain itself going forward.
- Strong momentum can continue in an upward or downward trend, which can be confirmed by changes in trading volume and other technical indicators.
- Momentum investing is a trading strategy in which investors buy securities that are rising and sell them when they look to have peaked.
- Momentum trading therefore describes a herding strategy, following others; but price trends are never guaranteed in the future.
Understanding Momentum
Think of it as the momentum of a train: When a train starts up, as it accelerates, it moves very slowly. Once it gets up to speed, it stops accelerating but remains traveling at a higher velocity. At the end of the trip, the train decelerates as it slows down, but it can take many miles of track to apply the brakes before finally coming to a complete stop. For the momentum investor, the best part of the train ride is in the middle, when the train is moving at its highest velocity.
Momentum investors like to chase performance. They attempt to achieve alpha returns by investing in stocks that trend one way or another. Stocks trending up are referred to as hot stocks. Some are hotter than others (as measured by growth over a period of time). A stock that is trending down is cold.
Investors can use momentum as a trading technique that seeks to profit from the herding behavior of market psychology. Rather than "buy low, sell high", momentum trading follows a strategy of "buy high, sell higher". Once a momentum trader sees acceleration in a stock's price, earnings, or revenues, the trader will often take a long or short position in the stock in the hope that its momentum will continue in either an upward or downward direction. This strategy relies on short-term movements in a stock's price rather than fundamental value.
When applied, an investor can buy or sell based on the strength of the trends in an asset's price. If a trader wants to use a momentum-based strategy, he takes a long position in a stock or asset that has been trending up. If the stock is trending down, he takes a short position. Instead of the traditional philosophy of trading—buy low, sell high—momentum investing seeks to sell low and buy lower, or buy high and sell higher. Instead of identifying the continuation or reversal pattern, momentum investors focus on the trend created by the most recent price break.
Special Considerations
Momentum Tools
Some tools for momentum investors help to define the trend, such as the trend line. A trend line is a line drawn from the high price to the low price, or vice versa, over a given time period. If the line is up, the trend is up and the momentum investor buys the stock. If the trend line is down, the trend is down and the momentum investor sells the stock.
In this way, momentum investing is purely a technical indicator. Though "momentum" can refer to fundamental measures of performance, such as revenue and earnings, it is most commonly used in reference to historical asset prices as a technical indicator.
Disadvantages of Momentum Trading
Just like any other trading style, there are risks that come with momentum trading. By using this technique, you should know that you are trading on the backs of other people in the market, and price trends are never guaranteed. And always be prepared for unexpected reversals or corrections that take place. This can happen because of unexpected news or changes in investor sentiment in the market.
