Momentum investing is a technique that seeks to profit from a market trend that is expected to continue. In investing, your common sense might say that you buy low and sell high. But momentum investing does not agree with this method. A momentum investor wants to buy high and sell even higher. This is what makes momentum investing a great concept.
Also, Momentum investing is a form of investment strategy that involves buying stocks that have been trending upward or short-selling stocks that have been trending downward. The key argument for momentum investing is that once a trend has been formed, it is more likely to continue.
There is no agreement among economists and finance experts on the topic of the validity of a momentum investing strategy. Economists like to define the effects of momentum investing with the efficient-market theory.
One theory says that investors bear a lot of risks while implementing a momentum investing strategy. Hence, high returns are the reward that balances it with the risk. Another theory states that momentum investors are leveraging the behavioral mistakes of other investors, like their nature of “following the herd”, also called the “herd mentality bias”.
What is Momentum Investing?
For ages, the heart of investing has been the concept of buying low and selling high. And this is where momentum investing is unlike normal investing.
Investors who practice momentum investing do not back down because of a high price or by the fact that the price of a stock is rising. Rather, momentum investors get attracted to a company whose price is on an upward trajectory.
Momentum investors put their hopes in the company and think that this upward price momentum will continue for some more time and which will enable them to sell at a higher price.
Nonetheless, momentum doesn’t need to be positive and upwards. There is also the downward momentum whose basic concept is that the stocks that have not performed well recently tend to go down even more in the short term.
It’s this low-lower and high-higher effect that the whole momentum strategy sticks to.
The Reason for Momentum Effect
There are two reasonable explanations for the momentum effect.
The first explanation is derived from behavioral finance which attaches it to investor bias. Investors usually under-react or overreact to information which leads to momentum.
A second explanation is derived which is related to timing. Investors slowly react to new information at the start and then do a hurried follow-up on it which is the reason for momentum.
And this follow-up nature is why momentum investing has been a short-term strategy since forever. It usually is adapted for over 6 to 12 months.
Building A Momentum Strategy
There are a lot of ways of creating a momentum investing strategy. In one of the strategies, there is a set of rules which aim at investing in the best-performing stocks over the past 6 months for the following 6 months.
Similarly, one can also short (sell) the worst performers from the past 6 months for the next 6 months.
“Shorting stocks” is a technique in which you first sell a stock and then buy it back after some time, thereby balancing your position. In other words, the short seller hopes that the cost of the stock will decrease and he can purchase the stock at a lower cost and make a profit in the process.
The NIFTY 200 Momentum 30 Index
Momentum investing is being used for over 200 years but was usually ignored as a branch of study till the 1990s. In the last 10 years or so, passive investing based on momentum strategies has come up and has seen a lot of traction.
There are two benchmarks based on momentum in India –
- The S&P BSE Momentum Index that has been up since December 2015
- And NIFTY 200 Momentum 30 Index, created by the NSE Indices in August 2020
Let us talk about the details of the NIFTY 200 Momentum 30 Index.
A momentum index is based on a set of rules and criteria that can be divided into 5 separate groups.
- The universe of stocks
- The basic construct
- The weighting criteria
- The constraints
- The periodic maintenance
The NIFTY 200 Momentum 30 Index, as is clear by the name, works around the top 200 companies that are listed on National Stock Exchange. The NIFTY 200 is a quite intimidating index that represents almost 87% of the free-float market capitalization of the stocks that are registered on the NSE.
Out of these 200 stocks, the momentum 30 index looks for companies that have been registered for at least 1 year and are available for trading in the derivatives or the F&O segment. These filters reduce the real number of stocks from 200 stocks to around 130 companies.
The NIFTY 200 Momentum 30 index takes 30 stocks from the available stocks in an unbiased rule-based way. The stocks that are chosen are based on their normalized momentum score. This score is created based on any stock’s 6 months and 12-month price return after modified for their daily price versatility.
The reason why the construct considers normalization and volatility is that its objective is to eliminate the impact of sudden spikes in the momentum score.
For example, think of a biotech company’s stock price suddenly spikes up after the launch of favorable clinical trial results. So while there is short-term upward momentum, it is also normal to see that these gains may not stay there for long.
Because of this, normalizing and modifying the selection criteria depended on volatility gives the momentum strategy a better chance to yield more results.
The NIFTY 200 Momentum 30 Index utilizes stock weights as a mixture of the stock’s modified momentum score and its free-float market capitalization.
In the free-float method, the market capitalization of a stock is computed by finding the product of its price by the number of shares readily available in the market.
Hence, this method does not include locked-in shares like the shares that are held by insiders, promoters, and governments.
Regarding constraints, the weights of any stock in the NIFTY 200 index have been capped at the lower of 5% or 5 times the weight of that stock in the index. This 5% capping is usually done to prevent portfolio uneven towards a particular stock and to make sure there is enough diversification.
Lastly, the index does a rebalancing on a half-yearly basis in June and December annually.
Characteristics of Momentum Investing
Momentum investing is a very technical strategy of trading. It is not like fundamental or value investors, as momentum investors are not worried about a company’s operational performance. Momentum investors imply technical indicators to the analysis of the stock to learn about trends and gauge the strength of the trend, say, to predict the level of price momentum in the market.
Momentum investors also try to analyze, interpret, and, if possible, anticipate the behavior of other investors in the market. Being aware of behavioral biases and investor sentiments can enhance the effectiveness of a momentum investing strategy very much.
Technical Analysis Tools in Momentum Trading
Technical analysis is the most important thing to do for momentum investors. Because traders spend a large amount of time trying to predict the strength of trends in asset prices, knowledge of key technical indicators is necessary to the successful execution of a momentum trading strategy.
These are some of the technical indicators that are prevalent in momentum trading:
Trend lines are technical analysis tools that are used for monitoring price movements. A trend line is made between two dots on a price chart. If the line made between two successive points is moving upward, then it means that there is a positive, bullish trend, and an investor should buy shares.
If the consequent line is sloping downward, then the trend is negative, or bearish, and this means you should be selling short as that is the most likely profitable position to adopt.
A moving average line lets traders understand the prevailing trend while removing much of the market “noise” that is created by small, insignificant price fluctuations.
If a stock’s price consistently remains at or above a moving average, this means that there is an uptrend. A downtrend is generally indicated on a chart by price showing a position at or below a chosen moving average.
The stochastic oscillator looks to differentiate between an asset’s most recent closing price and its prices over a certain time. If the closing price is around the high of the price range for that particular time, the trend is positive. If the closing price is around the low, this means a downward trend.
The values of a stochastic oscillator range from 0 to 100. Numbers more than 50 show a strengthening uptrend. Numbers less than 50, show that a downtrend that is gaining momentum. Though numbers below 20 show oversold conditions in a market that may cause a market reversal to the upside. Similarly, numbers above 80 show overbought conditions and the potential for a bearish reversal.
The Average Directional Index (ADX)
The Average Directional Index (ADX) is a famous momentum indicator and is generally considered less prone to producing wrong signals as compared to the stochastic oscillator. The ADX is used to predict the existence and the strength of a trend. It is done by computing the contraction or expansion of a stock’s price range for a certain time.
Values of ADX go from 0 to 100. Values less than 25 (some traders use 20 instead of 25) show a ranging, or directionless, market in which there is no clear trend.
Values above 25 show the existence of a trend, and values above that level show a stronger trend. In other words, an ADX value of 40 shows a stronger trend than an ADX value of 30.
Traders also seek separation between price movement and the ADX as a sign of decreasing or weakening momentum. If price creates a new high but the ADX does not show a new high value, that is the bearish separation of the ADX from price. On the other end of the chart, if the price decreases to a new low but the ADX does not show a new low value, that shows a bullish separation of the ADX from price.
Another famous momentum investing indicators is the Relative Strength Index (RSI) and the Moving Average Convergence Divergence (MACD) indicator.
How Momentum Investing Works
Traders applying a momentum investing strategy try to gain profit by either buying or selling short securities when they are trending strongly – i.e. when price action momentum is high. High momentum is shown by price increasing or decreasing over a wide range in a relatively short time. Markets with high levels of momentum usually show increased unpredictably too.
Momentum investing is short-term investing as mentioned above because traders are trying to capture part of the price movement in a trend. A momentum investing trade can be explained like this:
A trader utilizes technical indicators like trend lines, moving averages, and specific momentum indicators just like the ADX to find the existence of a trend.
If the trend finds momentum – gets stronger – the trader takes a market position in the way of the trend (buying an uptrend; selling a downtrend).
When the momentum of the trend gives signals of decreasing, such as a separation between price action and the movement of momentum indicators like the MACD or RSI, the trader tries to exit their position (hopefully at a profit), to avoid any actual trend reversal.
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