What is a momentum strategy?
The momentum strategy is an investment strategy with the aim of exploiting price momentum, i.e. entering a trend at the right moment, i.e. when it is gaining momentum, and exiting at the right moment. In other words, the investor buys securities when prices are on an upward trend and sells securities when the price increase levels off again. The difficulty lies in finding the right moment to enter or exit the market. The momentum strategy works with volatility by buying during a short-term upward trend. Selling takes place at the moment when the securities start to lose momentum. In technical analysis, momentum is often measured with the help of an oscillator, which is used to identify trends. A momentum investor tries to take advantage of the herd behavior of investors. For this reason, it is rather difficult for an inexperienced investor to implement a momentum strategy. In order to recognize the right moment and not miss it – in contrast to the large mass of investors – a high degree of specialist knowledge and experience is required. It can therefore be worthwhile relying on an experienced and independent asset manager to implement the momentum strategy. The risks of the momentum strategy include entering a position too early, exiting too late, being distracted and missing important trends and technical deviations.
The momentum strategy, herd behavior and the trend
Momentum investors want to achieve returns by investing in shares that are trending in one direction or another. In contrast to value investors, who are deliberately not guided by the trend, they focus on trend stocks. Shares that are on an upward trend are often referred to as “hot stocks”. The shares are measured by their price growth over a certain period of time. A share that is in a downward trend is “cold”. Momentum investors benefit from herd behavior and market psychology: they do not follow the famous Wall Street cliché “buy low, sell high” – buy low and sell high – but trade according to the principle: buy high, sell higher. As soon as a momentum trader detects a positive trend in the price, earnings or income of a share, he will buy the position with the aim of holding it for as long as the positive trend continues. In contrast to valueinvesting, the momentum strategy is based on short-term price movements – usually between 3 and 12 months – and not on the fundamental valuation of a stock.
Momentum indicators
Momentum investors use indicators to find the right moment for entry and exit. One example of this is the trend line. To create a trend line, a time period must first be defined. The trend line is the line that runs between the highest price and the lowest price in this specific period. If the line runs upwards, the trend is rising and the momentum investor buys the share. If the trend line points downwards, the trend is downwards and the momentum investor sells the share. As a result, momentum investing is a technical indicator. However, momentum indicators can also refer to key performance indicators such as turnover and profit. However, historical prices are most commonly used as a technical indicator.
For a more detailed explanation and further momentum indicators, please also visit the article on the125/250d AdjustedSlope.
Advantages of the momentum strategy
In general, momentum investing has the following advantages:
- High profitscan be made in a short period of time: Suppose an investor invests in a share because he expects the share price to rise on the basis of extensive analyses of analysts’ reports. The investor buys the share for CHF 100 before other investors realize the upward trend, after which the price actually rises to CHF 130. As the investor entered the stock in good time, he can now sell it for CHF 130 and make a profit of 30%.
- Talented investors manage to use volatility to their advantage.
- Good investors can benefit from irrational investors: Irrational investors react emotionally to information. Momentum investors can take advantage of precisely this herd behavior by exploiting the price volatility caused by irrational investors.
Disadvantages of the momentum strategy
Price trends are not always guaranteed. Unexpected market reversals or corrections can occur at any time, despite very intensive analysis and experience. In general, the momentum strategy has the following disadvantages:
- High share turnover can be expensive due to transaction costs.
- Time required: In order to be successful with the momentum strategy, market data must be monitored regularly so as not to miss the right moment.
- Market sensitivity: The momentum strategy is best implemented when share pricescontinue to rise. On the other hand, the profit margin decreases when prices continue to fall, as investors are more cautious.