Momentum investing is ideal for stock traders because it has a clear short (and medium) term aim. That is to buy winners and avoid losers. It sounds brute and over-simplistic. But it has proved effective.
Practically, momentum trading means buying stocks with proven performance history and dumping stocks that are not performing at the ‘moment’. This is a strategy that has real range, criss-crossing easily also across a range of commodities and currencies as well as stocks.
The usual caveats apply, of course: this strategy does not claim to work all the time. But it is a strategy that has proved robust and consistent. Simply, a history of previous past returns means likely future high returns.
Let the trend be your friend – four key points
- Momentum trading and investing means a stock trader places a position on any asset that’s showing a steady upward path. This is a rational move. Unless there’s negative news to the contrary that upwards journey will continue. (Keeping responses rational is excellent trading discipline.)
- Momentum trading and investing completely ignores fundamental pricing issues such as P/E ratios or debt levels. In other words, momentum investors invest in trends
- Momentum is about the speed of price change. Once this slows, so does momentum. Stocks that bob around sideways must be ruled out as they have no underlying direction or strength
- Momentum day trading can last a few minutes using highly targeted entry and exit points. Or it can last for several days, even months. The point is you buy, you hope, in the early stage of ‘momentum’, and you sell when it flags. It’s also equally fine to buy high and sell higher
Keep the ‘mo-mo’ going
The icing on the cake is that when momentum gets behind a stock, the quicker it climbs in value. That’s not just good news for stock traders because your trade is rising in value. It’s good news for your costs because rising asset values squash fees faster.
As far as longer term stocks and shares go, bear in mind momentum investing is relatively risk averse because you’re only investing for certain time periods. You review and make changes regularly.
However, momentum investing is still contrary or counter-intuitive because it often flies in the face of traditional stock-picking metrics and laborious time-intensive research, such as return-on-equity, cash flow or price-to-earnings.
“Momentum investing,” says Jon Horton of financial advisers Chamberlain de Broe, “can be great with a rising tide but beware of the turn of the tide. Tesco is a classic example. For years under Terry Leahy [Tesco boss until March 2011] if you wanted retail exposure you had to have Tesco.”
But then Tesco issued a shock profits warning, followed by a string of other warnings. Its share price, several years later in 2017, is still struggling, currently -12.5% year-to-date.
Identifying momentum stocks
Momentum stocks might be in the news or have strong consumer brand names. There is often strong volume movement attached to them. Momentum stocks can be more sensitive to regulatory, environmental or political news because of that – the price of being a ‘name’ (you’re warned).
- Momentum opportunities exist both at the large cap and small cap sector end and everything in between
- Watch for institutional backing. When big investment houses get behind stocks, that can really light a fire under a share price
- A record of consistently beating earnings updates is also a good indicator of ongoing momentum
Having said that, there is nothing wrong buying in the middle or even later stage – as long as momentum is maintained.
Tools for the job
For the stock trader these include technical aids such as momentum indicators. These measure the average price of an asset; their inputs are based on closing and opening prices and give a sense of averages over the short, medium and long term.
When the value of an asset accelerates past its moving average that is often a buy signal. Volume oscillators can suggest when a security is over-bought. You can also set up alerts to allow you to take action at certain points – to buy more, buy less or to sell.