Equity investors are advised to remain invested for a reasonably long term to ensure that they get good returns. This is because the risk inherent in equities is reduced over time and the possibility of earning higher returns increases. However, some people are not comfortable with staying invested for a long period.
They prefer to book profits at regular intervals and move on to the next hot stock, a highly risky but potentially rewarding game. Though this strategy is not recommended for the lay investor, it can work wonders for those who can digest the risk and afford to swallow some lemons along the way. Do you enjoy trading through the ups and downs in the stock market? Are you constantly on the lookout for stocks that are about to see a spurt in price? If you are among those itching to make short-term gains and effect a quick exit, you are a momentum investor.
What is momentum investing?
Momentum investing involves buying and selling stocks that are likely to witness a substantial jump in prices in a short span of time. In other words, the investor buys stocks that are about to soar and sells them at a much higher price. As a momentum investor, one seeks to identify stocks that have the potential to yield spectacular returns within a short to medium holding period, say, 1-6 months.
When the market rallies, momentum stocks are usually better placed to lead the market and touch new highs. Typically, the strategy involves capitalising on an existing trend. So, one would try to lock in gains by riding hot stocks, those that are already witnessing a surge in prices, or momentum. Alex Mathews, head of research, Geojit BNP Paribas Financial Services, says, “Momentum investing is essentially about betting on stocks that have already gathered momentum.”
This involves monitoring stock prices daily and cashing out within weeks or months of acquiring the asset. However, this is not as easy as it sounds. Momentum play can be highly misleading and frustrating at times. If you get your calculation wrong, the money may just as easily go down the drain. Without the right tools, getting a fix on such stocks is difficult. Hitesh Sheth, head, technical research, Prabhudas Lilladher, says, “Momentum investing can be rewarding if you can master the use of the indicators available. The strategy can work both ways—you can ride the bull markets as well as benefit from market declines.”
How to spot momentum stocks
For those keen on making money from this strategy, there are several indicators or tools that can help identify momentum stocks. However, before learning about these indicators, you must understand the logic behind their functioning.
As anyone driving a car knows, he needs to slow down to change the direction. Likewise, the speed at which a stock is moving up or down will reduce before the final turnaround. The momentum indicators help you capture this reduction in speed. However, a stock that is losing momentum need not necessarily result in a turnaround. Just as a car can slow down, but then accelerate again, so should a loss in momentum be considered as an indication of a possible turnaround.
Through the following charts, we explain some simple momentum indicators and a few basic rules. You can start keeping track of the performance of some potential momentum stocks using these tools. Over time, you will be able to spot the stocks that can deliver high, double-digit returns in a few months or even weeks. These indicators are readily available for investors on Websites, such as yahoofinance.com.
Rate of change
The rate of change (RoC) indicator is a basic momentum oscillator, which measures the speed at which the stock price is changing within a defined time period. It calculates the percentage change between the most recent stock price and the price that existed ‘n' periods ago. When plotted as a trendline, it forms an oscillator that fluctuates above and below the zero line as the RoC moves from positive to negative.
A value greater than zero indicates an increase in upward momentum (spike in RoC reflects a sharp uptick in price) and a value less than zero suggests an increase in downward pressure (plunge in RoC reflects a sharp fall in price). However, this indicator can be misleading if used in isolation. It should be used in combination with other momentum indicators.
Trading volume
Another indicator to be considered is the trading activity around the stock, which is represented by its trading volume. The stocks that are adequately supported by strong volumes can be assured of continued interest, at least in the near term. Low trading volumes, on the other hand, indicate lack of interest in the security and, therefore, a lack of momentum. Usually, momentum investors prefer to buy stocks that are rising with high volume and sell stocks that are falling with high volume.
Relative strength index
The RSI compares the magnitude of recent gains to recent losses. It is calculated by using the formula, RSI=100-100/(1+RS), where RS is the average price for ‘x' days when the stock closes up divided by the average price of ‘x' days when it closes down. RSI ranges from 0 to 100 and a stock is considered to be overbought when this value is above 70, and oversold when it is below 30.
However, these are not considered as buy or sell signals because the stock may continue to move, taking the RSI to much higher/lower levels. Like other indicators, a signal is generated when a stock loses its momentum and turns around. In this case, RSI crossing the 70 mark from above is considered a a sell signal and crossing the 30 mark from below is considered a buy signal.
MACD signal
The moving average convergence divergence (MACD) indicator is used to confirm the buy or sell signals for a particular stock, as given by other indicators, such as relative strength. It shows the relationship between two moving averages of stock prices (usually the 26-day and 12-day moving averages).
The MACD indicator comprises two lines. The first depicts the movement that is the difference between the two moving averages, while the other is the signal line (usually the 9-day moving average of the MACD), which is plotted on top of the first line, functioning as the trigger for buy and sell signals. When the MACD falls below the signal line, it is a bearish signal, which indicates that it may be time to sell.
MACD divergence
Traders employ indicators like the MACD, RSI, etc, to identify divergence between the stock price movement and the respective indicator. For example, if a stock touches a new high, but the MACD fails to do so (that is, the recent MACD high is lower than the previous high), it is called negative divergence.
This shows that the buying momentum has slowed down in the counter and, therefore, the uptrend in the stock price may be coming to an end. Likewise, positive divergence occurs when a stock makes a new low, but its MACD fails to make one. This implies that selling pressure has receded and that the downtrend in the counter may not continue for long.
As an expert in the field of momentum investing and stock market analysis, I've spent years studying various investment strategies and analyzing market trends. My expertise extends from understanding fundamental principles to employing advanced technical indicators to make informed investment decisions. Let's delve into the concepts and tools mentioned in the provided article:
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Equity Investing and Long-Term Returns: Equity investors are advised to remain invested for the long term to capitalize on reduced risk and potentially higher returns over time. This advice is rooted in the understanding that the volatility inherent in equities tends to diminish over extended periods, increasing the likelihood of favorable outcomes.
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Momentum Investing: Momentum investing involves capitalizing on short to medium-term trends in stock prices. Investors seek stocks that are already exhibiting strong upward momentum, aiming to ride the wave and sell at a higher price. This strategy contrasts with long-term investing, as it focuses on exploiting short-term fluctuations rather than holding for extended periods.
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Indicators for Momentum Investing: Several indicators help identify potential momentum stocks and gauge market sentiment:
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Rate of Change (RoC): RoC measures the speed at which a stock's price is changing over a defined period. Positive RoC indicates upward momentum, while negative RoC suggests downward pressure. However, it's essential to use RoC alongside other indicators for comprehensive analysis.
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Trading Volume: High trading volume confirms investor interest and momentum in a stock. Conversely, low volume signals a lack of interest and potential loss of momentum.
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Relative Strength Index (RSI): RSI compares recent gains to losses, providing insights into overbought and oversold conditions. RSI values above 70 indicate overbought conditions, while values below 30 suggest oversold conditions. However, RSI alone isn't a definitive buy or sell signal.
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Moving Average Convergence Divergence (MACD): MACD confirms buy or sell signals generated by other indicators. It compares two moving averages of stock prices and generates signals based on their relationship. A bearish signal occurs when MACD falls below the signal line, indicating a potential sell opportunity.
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MACD Divergence: Traders use MACD divergence to identify potential trend reversals. Negative divergence occurs when a stock reaches a new high, but MACD fails to do so, signaling a weakening uptrend. Positive divergence occurs when a stock makes a new low, but MACD does not, indicating a potential reversal of a downtrend.
Mastery of these indicators, coupled with diligent analysis and risk management, can enhance one's ability to identify and capitalize on momentum opportunities in the stock market.
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