What Is Momentum?
Momentum is the rate of acceleration of a security's price or volume – that is, the speed at which the price is changing. Simply put, it refers to the rate of change on price movements for a particular asset and is usually defined as a rate. In technical analysis, momentum is considered an oscillator and is used to help identify trend lines.
The Basics of Momentum Trading
Investors can use momentum as a trading technique. Once a momentum trader sees acceleration in a stock's price, earnings or revenues, the trader will often take a long or short position in the stock in the hope that its momentum will continue in either an upward or downward direction. This strategy relies on short-term movements in a stock's price rather than fundamental value.
When applied, an investor can buy or sell based on the strength of the trends in an asset's price. If a trader wants to use a momentum-based strategy, he takes a long position in a stock or asset that has been trending up. If the stock is trending down, he takes a short position. Instead of the traditional philosophy of trading – buy low, sell high – momentum investing seeks to sell low and buy lower, or buy high and sell higher. Instead of identifying the continuation or reversal pattern, momentum investors focus on the trend created by the most recent price break.
Think of it like the momentum of a train. When a train starts, it accelerates but moves slowly. In the middle of the trip, it stops accelerating but travels at a higher velocity. At the end of the trip, the train decelerates as it slows down. For the momentum investor, the best part of the train ride is in the middle, when the train is moving at its highest velocity.
Momentum investors like to chase performance. They attempt to achieve alpha returns by investing in stocks that trend one way or another. Stocks trending up are referred to as hot stocks. Some are hotter than others as measured by growth over a period of time. A stock that is trending down is cold.
Some tools for momentum investors help to define the trend, such as the trend line. A trend line is a line drawn from the high price to the low price, or vice versa, over a given time period. If the line is up, the trend is up and the momentum investor buys the stock. If the trend line is down, the trend is down and the momentum investor sells the stock.
In this way, momentum investing is purely a technical indicator. Though the "momentum" can refer to fundamental measures of performance, such as revenue and earnings, it is most commonly used in reference to historical asset prices as a technical indicator.
Risks to Momentum Trading
Just like any other trading style, there are risks that come with momentum trading. By using this technique, you should know that you are trading on the backs of other people in the market, and price trends are never guaranteed. And always be prepared for unexpected reversals or corrections that take place. This can happen because of unexpected news or changes in investor sentiment in the market.
- Momentum is the rate of acceleration of a security's price or volume.
- A trader will take a long or short position in a stock, hoping its momentum will continue in an upward or downward direction.
- Momentum trading happens on the backs of others and price trends are never guaranteed.