- Date : 15/05/2022
- Read: 5 mins
Conventional investment strategy involves buying low and selling high. However, momentum investing involves buying high and selling even higher. This blog examines the concept of momentum investing and how to frame an investment strategy.
You must have often seen a big movement in a stock price, either upside or downside. The big movement might have come over a day, week, month, or couple of months. When stocks show such a big movement on either side over time, it is known as momentum. This blog will focus on how to profit from momentum investing.
What is momentum investing?
Momentum is a term widely used in physics. But it has applications in other areas as well, including stock investing. Momentum investing in stocks is the rate of price movement and the time in which it happens. For example, a stock priced at Rs 200 moves to Rs 220 in a week. So, a momentum investor will interpret that as a 10% movement (rate of price movement) in a week (time period).
Momentum investing is used by traders to make quick money. It involves going with the trend, such as buying high and selling even higher, rather than conventional investing, which involves buying low and selling high.
Momentum can be in either direction
Stock prices move in either direction. So, stock momentum can be either on the upside or on the downside.
a) Upside momentum
When a stock shows an upside momentum, an individual investor can buy and hold it to make a profit.
Chart: Adani Green Energy Ltd. 6-month price movement
The above chart shows how Adani Green Energy Ltd.'s share price increased from Rs 1226 to Rs 2856, more than doubling in 6 months (November 2021 to May 2022). So, this is an example of 6 months of momentum on the upside.
b) Downside momentum
When the share price continuously falls, an investor can sell it in the futures and options segment to profit from the downward price movement.
Chart: Apollo Hospitals 1-month price movement
The above chart shows how the share price of Apollo Hospitals Enterprise Ltd. moved down from a high of Rs 4885 to a low of Rs 3834, losing 15% in 1 month (April-May 2022). So, this is an example of 1-month momentum on the downside.
Points to remember for momentum investing
To benefit from momentum trading, you should keep the following things in mind:
a) Go with technical indicators
Stock momentum is linked more to technical analysis indicators than fundamentals, at least in the short term. So, you should look for signs of a technical breakout to go long on a particular stock or index and profit from it. Similarly, you should go short on the stock or index if you notice a breakdown sign.
b) Keep stock fundamentals aside for the short term
As mentioned earlier, the price movement follows technical indicators in the short term. In the long term, the fundamentals decide the share price movement. So, in momentum investing, you should keep aside the stock fundamentals for the short term.
For example, Asian Paints has strong fundamentals. But, a big spike in crude prices can affect it in the short term. On 7 January 2022, the share price hit a peak of Rs 3576. On 24 February 2022, Russia invaded Ukraine, which led to a flare-up in crude oil prices. Due to this, the Asian Paints share price had a sharp fall to hit a low of Rs 2708 on 7 March 2022, thereby losing more than 20% in two months.
A momentum trader can profit by going short on good stocks like Asian Paints during such events. So, in momentum investing, you should keep stock fundamentals aside for the short term.
c) Be wary of major events
You should be wary of major events like the COVID-19 pandemic, sub-prime crisis, etc., leading to sharp sell-offs of the stock market. During such events, if you have gone long on a stock with positive momentum, the direction can reverse quickly, leading to losses.
Framing a momentum investing strategy
To build your momentum investing strategy, take the following steps:
1) Select the Nifty 50 Index or the broader Nifty 100 Index for picking stocks
2) Filter the stocks based on, for example, the top five gainers and top five losers over one week, month, or quarter.
3) You can use the top gainers to go long and the top losers to go short.
4) You should apply risk management tools to define how much exposure you want to take to each stock, put stop losses in place, etc.
5) With time, you should rebalance the list of stocks either every week, month, or quarter.
If you plan to do momentum investing, you should bear in mind that it can be a double-edged sword. While momentum investing has the potential to yield high profits, it can also lead to big losses if the price goes in the opposite direction of your trade. So, consider the pros and cons of momentum investing and then make an informed decision.