Momentum investing is an investment strategy that aims to capitalize on the continuance of existing trends in the market. To participate in momentum investing, a trader takes a long position in an asset that has shown an upward trending price, or the trader short-sells a security that has been in a downtrend. The basic idea is that once a trend is established, it is more likely to continue in that direction than to move against the trend.
Value is a long-term strategy, whereas momentum is a short-term strategy. There is room for both philosophies in the stock selection process, but these are two fundamentally different investment strategies. The value investor believes that a stock can become overvalued or undervalued based on relative earnings or discounted cash flow measures. In this way, the fundamental analyst is more interested in the direction of sales and expenses than price. If the price is down and the price-to-earnings (P/E) ratio suggests the stock is undervalued, value investors want to buy – in other words, the company dictates price, not the emotion of the investor or market. The momentum investor is not concerned with operational performance, at least not from a pricing perspective. Momentum investors are technical analysts who thrive on investor emotion. They look at indicators that help to track the trend and spend a great deal of time looking for patterns that confirm trend continuation.
There are a number of momentum indicators traders use in addition to monitoring the movement of price. The most basic and common tool is the trend line, which is drawn between two points on a price graph. If the line is going up, the trend is up, and momentum investors see this as a buy signal. If the line is sloping down, the trend is down, and momentum investors see this as a sell signal.
Another tool traders use is the 50-period moving average. When the price drops below the 50-period moving average, it is a confirmation that the price is trending down and a signal for momentum investors to sell. Likewise, when the price moves above the 50-period moving average, it is a confirmation the price is trending up and the a signal for the momentum investor to buy.