Newton’s first rule of motion states that unless an external force acts upon a body, it will continue to move in a straight path. This theory was termed as ‘Momentum.’ Even though the term ‘momentum’ came from the study of mass and velocity, it quickly spread to other industries, like investment and sports.
The common wisdom in investing states that you should buy low and sell high. However, momentum investing goes against this accepted approach. An investor with momentum seeks to purchase high and sell even higher. This adds intrigue to the idea of momentum investment.
In this blog, we will explain everything you must know about momentum investing.
What is Momentum Trading?
Fundamentally, momentum trading is a method of selecting which stocks to purchase and sell by closely monitoring technical indicators in the stock market. Purchasing winners and avoiding losers is the plan. Price uptrends and downtrends are inevitable in the stock market.
Most investors using a typical investing approach will estimate a company’s likelihood of success or failure in the far future. Typically, this traditional approach to investing entails placing wagers during a company’s early stages in the hopes that it would eventually become a big success.
Momentum trading completely opposes such a strategy for trading. Rather, it uses momentum techniques to forecast price movements over shorter periods. Momentum traders look into the latest trends using technical analysis to find stocks that are now rising. It intends to purchase the best ones like Edelweiss Nifty Midcap 150 Momentum 50 Index Fund and sell them when they reach their top.
The momentum trader then purchases the stocks in accordance with their pre-established criteria using automatic trading algorithms or experience. Usually, momentum traders create boundaries for their trading by starting with certain price movements they are searching for. The foundation of momentum investing is these momentum indicators, which are frequently adhered to precisely.
Essential Things to Know About Momentum
- Strong markets are ideal for momentum to work in. When you think about it, a momentum investor is more likely to be “buying high and expecting prices to go higher” than “buying low and selling high.” It follows that the plan would be successful as long as markets remain robust.
- Instead of being a “buy and hold” approach, momentum is a high turnover one. The most successful momentum methods may capture long-term trends. But occasionally, the trend may break, and other companies or sectors gain attraction. As a result, momentum investors sometimes experience more stock picker turnover than fundamental investors.
- Any company can provide momentum with schemes like Edelweiss Nifty Midcap 150 Momentum 50 Index Fund. A momentum approach does not favour any particular industry, stock, or large- or small-cap company. Various industries gain traction at different points during the business cycle.
- Momentum isn’t perfect. Choosing stocks based on momentum may be problematic, particularly in a volatile emerging market like India. In the past year, momentum favourites Adani stocks, and IRCTC saw extreme volatility when the trend halted. Therefore, working with risk controls is wise while trading momentum in India.
Types of Momentum Investing Strategies
There are two primary types of index fund momentum investment strategies: time-series momentum and cross-sectional momentum. Time-series momentum involves assessing an asset’s current performance compared to its historical performance. For instance, one might rank stocks based on their 12-month performance to identify which ones have demonstrated stronger performance.
Time-series momentum can be determined using a specified profit percentage threshold, and typically, assets or shares exceeding this threshold are acquired. On the other hand, relative momentum involves comparing the performance of a particular asset to that of similar assets. For example, if gold gained 15% over the year while stocks gained only 12%, gold has a higher rate of change than stocks.
The Benefits of Momentum Trading
How lucrative is momentum trading on average? It can be highly profitable. According to a recent study that analyzed stock prices and chart pattern data dating as far back as 1801, momentum investing, on average, yields a 0.4% monthly return on investment.
However, the same study also revealed that momentum investing is more susceptible to volatile markets’ impact than conventional investment strategies. The study’s authors noted seven decade-long periods where momentum investing did not prove profitable, with the early 21st century being one such period. As a result, momentum traders should exercise caution and thoroughly assess current and anticipated market volatility.
Furthermore, the effectiveness of index fund momentum trading has started to diminish, particularly as market conditions become more prolonged and stable. During extended, predictable bull markets, momentum traders tend to achieve less favourable returns than in the initial phases of a bull market. In other words, the effectiveness of momentum diminishes as a bull market’s duration increases, and the likelihood of a swift transition into a bear market becomes more imminent.
Investors should be aware of the risks of using a momentum investing approach. This includes investing in an asset class solely based on what other market participants are doing. It is impossible to predict if a purchase of this nature will prevent price increases.
Empirical evidence and back-testing techniques support the viability of momentum trading methods. When applying these tactics, investors should keep the aforementioned considerations in mind.