What is Momentum Investing?
Momentum investing is an investment strategy aimed at purchasing securities that have been showing an upward price trend or short-selling securities that have been showing a downward trend. The main rationale behind momentum investing is when the trend is established, there is a great probability that it will continue.
There is no consensus among economists and finance professionals regarding the validity of momentum investing strategy. Also, economists try to explain the effects of momentum investing using the efficient-market theory.
One hypothesis states that investors bear significant risk while taking momentum strategy; high returns are the reward for that risk. The other hypothesis assumes that momentum investors are leveraging the behavioral weaknesses of other investors such as the investors’ overreaction, underreaction, or disposition effect.
Characteristics of momentum investing
Momentum investing is a short-term strategy. Unlike value investors, momentum investors are not concerned with a company’s operational performance. Momentum investors apply technical analysis to determine the pricing of shares. In addition, momentum investing requires identification of the momentum by using different technical indicators.
Finally, momentum investors need to understand and analyze the behavior of other investors in the market. The awareness of behavioral biases and investors emotions may significantly leverage the momentum strategy.
Momentum technical analysis tools
Technical analysis remains the primary analysis tool for momentum investors. Since traders spend a significant amount of time on determining the trends in asset prices, knowledge of the main momentum indicators is crucial to the successful execution of the momentum strategy. The essential momentum indicators are:
1. Trend line
It is the most basic tool for monitoring price movements. A trend line is drawn between two points on a price graph. If the line is going up, it indicates that there is a positive trend and an investor can buy shares. If the line is going down, the trend is negative, and the investor needs to sell the shares.
2. Moving average
The moving average allows investors to eliminate the “noise” from random price fluctuations. When the price exceeds the moving average, it is a signal of an upward trend; when the price is lower than the moving average, the trend is negative.
3. Stochastic oscillator
The stochastic oscillator compares an asset’s closing price to the prices over a certain period. When the closing price is near the high, the trend is positive; when the closing price is near the low, there is a downward trend.
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