Investors then receive their money, look for the next short-term uptrend or buying opportunity, and repeat the process. An experienced trader knows when to enter a position, how long to hold it, and when to exit it. It also handles short-term spikes and dips caused by news. The risks of momentum trading include entering a position too early, exiting a position too late, diversification, and missing important trends or technical differences.
Momentum Strategy
A Momentum Strategy can be developed for each stock with the goal of measuring the momentum of all stocks in the tracking universe and trading the ones that show the highest momentum. Note that momentum can be either long or short, and traders who follow the single stock momentum strategy are given both long and short trading opportunities. Momentum can also be applied on a portfolio basis.
It includes the concept of creating a portfolio of, say, a number of stocks and each stock in the portfolio has momentum. In my opinion, this is not only the usual strategy but a good one as it provides security in terms of diversification.
Types of Momentum Investments
Momentum investments can generally be divided into two categories: relative momentum investments and absolute momentum investments.
1. Relative Investment Momentum
In this case, the investor compares the relative performance of the securities, buys the high performing stocks and avoids or shorts the low performing stocks. They then rebalance their portfolio at regular intervals and rotate between a subset of securities. Relative momentum is also known as cross-sectional momentum investing.
2. Absolute dynamics of investing
In this case, investors compare the security with its historical performance. They buy securities that have produced positive returns and sell securities that have produced negative returns. Absolute Momentum is also known as Time Series Momentum or Trend Following.
The difference between the two is that relative momentum does not take into account whether returns are negative or positive. Investors invest in the least depreciating asset, even if all the securities are depreciating. Yield direction, on the other hand, plays an important role in absolute momentum. Investors avoid stocks that generate negative returns and only invest in stocks that generate positive returns.
Should you try momentum investing?
You can try momentum investing if you are a market-savvy investor with a higher risk tolerance. Additionally, momentum investing can be appropriate when stock markets are outperforming. The momentum approach to investing is not biased towards a particular sector, market cap or stock. It has the potential for high profits in a short period of time. These are lucrative profits that can be made from momentum investments. Take advantage of market volatility. Key to momentum investing is the ability to profit from volatile market trends.
Momentum investors look for rising stocks and sell them before prices start to fall. For such investors, staying ahead of the competition is a way to maximise return on investment (ROI). According to Ben Carlson of the Wealth of common-sense blog, the whole idea of momentum investing is based on the pursuit of performance. However, momentum investors do so systematically, including specific buy and sell discussions. Rather than being driven by emotional reactions to stock prices like many investors, momentum investors seek to capitalise on changes in stock prices caused by emotional investors.
Beware of the Risks
Momentum investments offer high returns but carry high risks. When trends break, analysts like to beat momentum stocks for higher valuations. These risks can be mitigated through diversification, strict stop-loss and deallocation policies, and dynamic adjustment to market scenarios. There is a recurring suspicion among investors that Momentum is not a long-term strategy because it seeks to capture short-term trends.
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