Momentum is the observation that financial assets trending strongly in a certain direction will continue to move in that direction. The concept of momentum is based on similar theories in physics, where an object in motion tends to stay in motion unless disrupted by an external force.
In finance, momentum refers to the notion that assets increasing in price will continue to increase, and assets decreasing in price will continue to decrease. The entire concept of momentum is based on the observation that trends in the prices of financial assets tend to continue in the same direction. By analyzing the momentum of assets, such as stocks, investors can determine which assets to purchase to capitalize on upward or downward price trends.
Momentum is the observation that financial assets trending strongly in a certain direction will continue to move in that direction.
To calculate momentum, returns are measured over time to determine the rate of momentum over a specific time period.
Traders can use the direction of price trends to make buy or sell decisions, also known as momentum trading.
Fundamentally, momentum is the observation that asset prices tend to increase or decrease based on the direction of recent trends. Although the concept typically refers to the prices of securities, such as stocks, it can also exist in a wider range of financial assets, such as real estate or corporate bonds.
To calculate momentum, returns are measured over time to determine the rate of momentum over a specific time period. For example, a stock’s six-month momentum is equivalent to its performance over the past six months. Securities with positive returns over time are described as showing positive momentum, while securities with negative returns demonstrate negative momentum.
Abnormality of Momentum
The presence of momentum is the result of anomalies in the financial markets. The Efficient Market Hypothesis states that asset prices reflect all available information, and only new information should affect asset prices. Past performance should not be an indicator of future performance, and the fact that stock prices are increasing should not be a reason for further increases.
Therefore, assuming the efficient market hypothesis holds, momentum should not exist. However, some researchers attribute the anomaly of momentum to investor irrationality. While the efficient market hypothesis assumes rational behavior, momentum may be attributed to irrational behavior, such as cognitive bias or other behavioral effects.
To take advantage of momentum in the markets, traders can utilize the direction of price trends to make buy or sell decisions. Traders can profit from buying securities during periods of positive momentum or short-selling securities during periods of negative momentum. Contrary to the typical advice of “buy low and sell high,” momentum trading focuses on riding the upward or downward trends in the price of a security.
Momentum traders are betting on the likelihood that the price of a security will continue to move in a certain direction up until the trend comes to an end. However, past performance is not a predictor of future performance, so there is still risk involved with momentum trading, as it can be difficult to predict whether a price trend has reached the peak or hit the bottom.
Absolute vs. Relative Momentum
When employing momentum trading strategies, there are two main categories that traders can engage in:
Absolute momentum is a strategy that compares the price of a security against its historical performance. When employing an absolute momentum strategy, a trader should buy when the momentum is positive and sell when the momentum is negative.
For example, if the 12-month momentum of a stock is significantly positive, a momentum trader would purchase more shares. In contrast, and a trader would short-sell shares if the 12-month momentum were negative.
Relative momentum focuses on comparing the performance of different securities and purchasing the ones that demonstrate a higher rate of momentum. Suppose you own shares in Company A with a 12-month return of 10% and shares in Company B with a 12-month return of 35%. Following a relative momentum strategy, a trader would increase their shares in Company B and decrease their shares in Company A.