Momentum Investing: Riding the Trend

As students, we have learnt about Newton’s First Law of Motion, which states that an object at rest will remain at rest, and an object in motion will stay in motion, unless acted upon by an external force.

Momentum investing relies on the same idea that stocks that have been performing well in the recent past are likely to continue to do so, as they have already established a trend in a certain direction. Just like an object in motion, these stocks have built up momentum, and investors hope to ride that momentum to capture gains as the trend continues.

With the basic premise of momentum investing set, let’s dive deeper to understand how to identify stocks for momentum investing, which tools to use, and the pros and cons of it.

How to Identify Stocks for Momentum Investing?

There are more than 5,000 stocks listed on the BSE and NSE to choose from. This means you will need to do some initial screening to ensure you pick the right stocks for momentum investing. To do so, you can use the following:

• Stock’s recent performance: Look for stocks that have shown consistent gains over the past few months or even years. This is the primary condition that we need as we are betting on the fact that the upward momentum of stock will continue. 

• Stock’s fundamentals: Look for stocks with strong financials like earnings and revenue growth, and a healthy balance sheet. A stock with good fundamentals attracts more investors willing to invest in it and has the strength to carry on the rising trend in the near future. If a stock’s fundamentals are weak, the upward trend might not continue, and your investments could end up losing money if the trend reverses.

Which tools are used to identify stocks for Momentum Investing?

Several indicators are available at investors’ disposal to identify stocks for momentum investing. These indicators are generally used for the technical analysis of stocks. They use price and volume as key factors to assess a stock’s momentum.

Here are some popular tools you can use for identifying momentum 

• Moving Average: A moving average line helps traders identify the current trend by smoothing out small price movements that may not be significant. If the price consistently stays above the moving average, it suggests an uptrend, while if it stays below, it indicates a downtrend on the chart.

• Moving Average Convergence/Divergence (MACD): This momentum indicator measures the relationship between two moving averages of a stock’s price. It generates buy or sell signals when the MACD line crosses above or below the signal line. Investors can also use the MACD histogram to identify the strength of the momentum. The MACD is widely used in momentum trading to identify potential buy or sell signals and confirm the trend’s strength.

• Relative Strength Index (RSI): The RSI is calculated by comparing the average gains and losses of a stock over a specified period, typically 14 days, and plotting the result on a scale from 0 to 100. It can be used as a confirmation signal for momentum investing, with a high RSI suggesting the stock may be overbought and a low RSI indicating it may be oversold, helping traders decide when to enter or exit a trade. 

• Bollinger Bands: They measure the volatility of a stock by plotting two standard deviations above and below a moving average. Investors can use Bollinger Bands to identify overbought or oversold conditions and potential trend reversals.

Many other technical indicators, like the stochastic oscillator, the Ichimoku cloud, etc., can also be used to identify momentum-based stock trends.

Pros of Momentum Investing

Like any investment strategy, momentum investing has its pros and cons. Some of the advantages of this strategy include:

• Good Returns: Momentum strategies have historically provided strong returns, particularly during bull markets. Investors can capitalize on upward trends by buying stocks with strong momentum and holding them until the momentum begins to fade.

• Easy to Follow: Momentum investing relies on specific technical indicators that are easy to understand and follow.

• Quick Decisions: Momentum traders make quick decisions based on technical indicators, allowing them to capitalize on short-term price movements in the market.

• Risk Management: Momentum strategies include stop-loss orders and other risk management techniques to limit potential losses if the momentum reverses.

• Diversification: Momentum investing can be applied across different markets and asset classes, allowing investors to diversify their portfolios.

Cons of Momentum Investing:

There are also some potential drawbacks to momentum investing. 

• Manually screening stocks for momentum investing can be time-consuming for a retail investor.
• Trends can be short-lived, and stocks trending upward can quickly reverse course. 
• Momentum investing can be highly volatile, and investors must be prepared for significant stock price swings. 
• Momentum investing can also be more susceptible to market downturns, as stocks that have been trending upward are often more expensive and, therefore, more vulnerable to market corrections.

How WealthBaskets focused on Momentum Investing work?

Artificial intelligence and machine learning technologies have made the task of screening and identifying potential stocks for momentum investing easier. But developing AI/ML models and training them is an expensive affair that requires niche technical expertise in finance and computer science.

Curators on our platform offering momentum based WealthBaskets have mastered the domain and generated significant value for investors’ portfolios. Thus, investing in WealthBaskets curated by SEBI professionals, gives one an advantage over other retail investors.

You can check out a few such WealthBaskets here:

OpenQ Defensive Momentum Curated by Quantech Capital

Alpha Momentum Curated by Renaissance Investment Advisors

Momentum Moguls Curated by Elever Investment Adviser

Conclusion

Momentum investing is a strategy that involves buying stocks that have been trending upward in price in the hopes of capturing gains as the trend continues. While this strategy can be highly effective, it also has its risks, including short-lived trends, volatility, and susceptibility to market downturns. By taking a measured approach and carefully considering the risks and rewards, investors can potentially benefit from the momentum investing strategy.