Momentum investing.

What is momentum investing? 

Momentum investing focuses on market trends, and it ties closely to behavioural economics. Investors buy stocks that are going up and aim to sell at the peak for profit. They use strategies to spot trends and predict when the rise will end. If they wait too long and prices fall, they risk a reduction in gains or even losses. Timing is key for the largest profit. 

How momentum investing works

Imagine this: a company announces exciting news. It could be about a new product or a strong set of results. This kind of news typically should boost the company’s stock price. Yet, investors might not immediately react as they should. They could be hesitant, sceptical of the news, or waiting to see how others react. This behaviour is what we call "underreaction."  

As a result, while the stock price does go up, it does so more slowly than expected. Momentum investors seize this chance. They buy the stock early, expecting that more investors will catch on. Investors will drive the price even higher.  

As demand grows and more people recognise the company's positive developments, the stock price continues to climb. Momentum investors track the stock as it approaches its highest value point. They sell before a potential decline, boosting their profits from the rise. 

What are momentum indicators? 

Momentum indicators are tools that show the strength of a price trend, helping investors decide when to buy or sell.  

The Relative Strength Index (RSI) is a trading tool. It measures the speed and change of price movements and helps traders see if a stock or asset is overbought or oversold. 

RSI is a number between 0 and 100. When RSI is above 50, the price is going up (positive momentum). When RSI is below 50, the price is going down (negative momentum). If RSI goes above 70, the asset may be overbought, meaning it could be overpriced and might soon decrease. If RSI goes below 30, the asset might be oversold, meaning it could be under-priced and might soon increase. 

The Moving Average Convergence/Divergence (MACD) is a tool that helps investors identify price trends, measure momentum, and find good times to buy or sell.  

It compares two averages, the MACD and signal line, of an asset’s price. The MACD line is created by subtracting the 26-day average from the 12-day average. A 9-day average of the MACD line, called the signal line, sits on top of the MACD line to trigger buy or sell signals. Traders often buy when the MACD line crosses above the signal line and sell when it crosses below.  

Rate of Change (ROC) is a momentum indicator that displays the percentage change in price from a previous period to the current one. It is vital for investors as it helps identify whether a security is gaining or losing momentum. A positive ROC indicates an increase in price, while a negative ROC indicates a decrease.  

To visualize the Rate of Change (ROC) formula, let's break it down with a step-by-step calculation: 

(Current Price - Price n periods ago) / Price n periods ago)] x 100. 

Example: ((10−7) ÷7) ×100=42.85

A 52-Week High can be a signal of upward momentum as stocks close to their highest price in the past year usually perform better than those further from it. Investors use this high point as a reference to assess stocks. 

Momentum investing: benefits and risks 

Trends are not permanent, and markets are at a constant risk of direction changes, which can result in either reduced profit or even losses for momentum investors. It is important to recognise that past performances do not guarantee future outcomes, and trends have the potential to reverse rapidly.