How to invest for momentum?
Inertia is a well-known quantity in physics, which implies that bodies tend to retain their state, whether of rest or motion. This trend is also transferred to other areas of life, in which we do many things “by inertia,” or as the saying goes, “the human being is an animal of habit.”
What is Momentum Investing?
According to the dotbig.com website the momentum investing is based on a similar principle, estimating the security trend will continue in the short term, so if it recently improved its price, it will continue to do so. If you fall, the trend will continue to the low soon.
Trend and acceleration
The momentum of action is also related to another physical magnitude, the acceleration (or deceleration). We care if the trend is positive (or negative, reversed shortly) and accelerating or slowing down. The acceleration or deceleration of the movement indicates that the trend may be changing since it is losing strength.
Is the technician fundamental?
Therefore, the investment by momentum would be framed within the technical analysis, using indicators to analyze how the trend evolves.
What is the momentum based on?
One possible explanation that makes momentum make sense is that it takes investors a while to incorporate information about the stock, so the trend persists to some extent. When the trend is positive, it attracts investors to that value, reinforcing it in the older days.
Continuing with the simile of our daily life, it would be something similar to the situation in which we are going to have a drink and enter the busiest place – thinking that it will be better for that – while others remain empty because no one enters – since they are empty, it will be for something.
How the momentum indicator is calculated
The moment or momentum measures the price variation of an asset, comparing the close of the day with that of “x” sessions ago (generally 10 or 12).
- If the current price is equal to x sessions ago, the momentum is zero (or 100, depending on the scale used).
- If the current price is higher, the momentum is positive, and if it is lower, the momentum is negative.
- Momentum greater than zero and rising indicates that the trend is bullish and accelerating. On the contrary, a momentum less than zero and decreasing (increasingly negative) indicates accelerating the downtrend.
Momentum: always riding a wave
There would be two different systems to generate signals with this indicator.
- As an indicator of change in trend, it would give buy signals when it is above that neutral level and sell when it goes down.
- As an indicator of exhaustion of a trend, it would give a sell signal when the slope of the momentum goes from positive (bullish) to negative (bearish). In this case, we would be exiting an uptrend on the crest of the successive waves that the indicator is forming, which signals the moment when the uptrend begins to slow down.
The investor for momentum tries to flow with the market, riding the waves that go upwards, to move on to the next when they begin to loosen. In the first system, the sale occurs when it crosses the neutral line at the base of the wave, while in the second, it is sold at the crest when it begins to decline.
The indicator values can be easily consulted on a trading platform, and using graphs, a more comfortable interpretation is achieved.
Momentum plus other ratios
The momentum indicator is often used in conjunction with other ratios, allowing trends to be further refined. Thus, for example, moving averages (simple or exponential) can be used to see the consistency of the movement, softening a little the peaks that may be punctual. Moving averages with more or fewer periods will be chosen depending on the period being considered, although the most common are 10, 20, 50, 100, and 200 periods.
Other indicators commonly used to complement the momentum strategy are the momentum oscillators that allow estimating the strength of this movement. For example, the RSI, Relative Strength Index, or Relative Strength Index. In this indicator, level 50 would be neutral; after 70, it would indicate overbought of the security (which would mean that it would have to be sold), and, below 30, it would be oversold.
What complications can this strategy have for its application
Volatility distorts trends
Without going into valuations here on the advantages or disadvantages of technical analysis, or if it is a superior or inferior system to that of the investment in value, the selection of actions by their momentum is complicated in high volatility situations since it is more difficult to define trends.
Like any “automatic” system, it is not infallible and can give rise to false signals. There may also be turns in the market or in the fundamental situation of the company that produces unanticipated changes.
In addition, in a strategy of this type, transaction costs must be considered. If we frequently change values, commissions, taxes, and fees can take a significant part of the profitability that we can achieve.
Without neglecting the risk profile
As in any investment, the balance between profitability and risk must be taken into account, in addition to the investment profile. If the momentum rises or falls excessively fast, underlying causes may influence the value, so it is advisable to act prudently.
Without forgetting the investment strategy
As in other strategies based on technical analysis, it is also important to properly define the exit strategy, setting a stop loss to limit losses in cases where the security behavior is not as expected.
By its very nature, momentum is not permanent; it has a limited duration in time, so a constant evaluation is required to examine if the portfolio of securities still has “momentum” and, on the other hand, if there are alternative values that they are in a better moment.