In general, momentum refers to the force or speed of movement; it is usually defined as a rate. In the world of investments, momentum refers to the rate of change on price movements for a particular asset – that is, the speed at which the price is changing.
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.
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 is accelerating, but it is moving slowly. In the middle of the trip, it stops accelerating, but it is traveling at a higher velocity. At the end of the trip, the train is decelerating as it begins to move slower. 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 are trending in 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.