For many years, traditional mantra of equity investors has been simple: “Buy low, sell high”. The strategy behind this saying is called “value investing” and it relies on buying shares that are fundamentally undervalued and holding them until they appreciate to their underlying value.
Recently we have presented a report on short-term “Dividend Plays” that offers an alternative to long-term buy-and-hold approaches. In this report, we seek to identify other profitable short-term market opportunities, which can be used by savvy traders as an alternative to buy-and-hold investing.
FTSE 100 index of UK blue-chip stocks has been rising steadily over the past quarter and the late May of 2018 has seen the index reach all-time highs.
One example of a stock that has benefited from FTSE’s positive momentum is NMC Health. This UAE-based healthcare provider has seen its shares grow by leaps and bounds over in the recent years.
- 2015: +82.7% (#1 FTSE 100 performer)
- 2016: +83.7% (#3 performer)
- 2017: +86.9% (#1 performer by 30%)
- 2018: +30% year-to-date (#4 on FTSE 100)
Riding these kinds of market waves lies at the heart of a strategy called “momentum investing”.
But what is this momentum? How can it be expressed and quantified, and can investors benefit from studying technical momentum indicators to identify shares to buy or sell?
In the context of the stock market, momentum refers to the speed at which the price of the stock changes. When the share price is quickly going up, the stock is said to have “positive momentum” and, conversely, when the prices are quickly going down, these shares have “negative momentum”.
That seems intuitive enough, but how does that help an investor profit? Can a speed of change in the share price tell investors something about which stocks to invest in and which to avoid?
A traditional investor will “buy low and sell high”, but a momentum investor will instead “buy high and sell higher”. Instead of looking at fundamental criteria such as earnings and P/E ratios, momentum investors will look purely at technical indicators, such as trend lines and moving averages.
At its core, momentum investing is about understanding the psychology of the market and how traders tend to “rush” into certain stocks and drive them up or down not just based on fundamental value, but also because of emotion and market inertia. The goal of momentum investing is to identify and profit from such bull rushes.
Here at Accendo Markets, we are looking to empower our clients with expert knowledge and understanding of the markets that goes beyond inflexible, dyed in the wool investment techniques.
This report will demonstrate ways to identify profitable market momentum opportunities and evaluate stocks that have recently been experiencing positive momentum.
Read on to find out more about momentum investing and sign up to have our research sent directly to your inbox.
Full Speed Ahead
A powerful trend can feel intimidating to both inexperienced investors and seasoned market professionals. Many traders are often hesitant to take advantage of strong directional movements of share prices because they might feel that they have already missed their chance.
They reason that by the time they have spotted a developed trend and entered a position, it will already be too late to secure any meaningful gains, that the trend will hit some support or resistance line and reverse, leaving them with losses.
However, this logic runs contrary to the basic principle of technical analysis. When a trend is established, up or down, technical analysts assume that it is more likely to continue in that direction than reverse. Unless there are more compelling reasons for the share price to stop moving upwards or downwards, that trend will continue moving from one high or low to another.
Even if the share price has already risen by a significant amount or the uptrend has been happening for a long period of time, it is likely to continue going up as long as the trend is still valid.
Buy what makes a trend valid? What market forces sustain uptrends and downtrends? Ironically, one of the strongest factors that drive trends are emotions and psychological reactions of investors.
Investors are subjected to powerful emotional stimuli that encourage them to trade certain stocks and drive their share prices up or down. Some companies can become “story stocks”, with investors feeling a sense of pride, accomplishment and belonging just from owning certain company shares (Apple and Alphabet are good example of such “story stocks”).
Market traders are also not immune to being subjected to “herd mentality” by investing in certain shares because their peers and competitors do so as well. Instead of buying and selling shares because of their underlying value or because technical indicators support these trades, such investors buy shares because they feel an emotional attachment to the brand name.
Running with the Bulls
Emotional investment is especially powerful during bullish markets, when many investors are feeling optimistic and become more eager to buy. In bearish markets, investors are naturally more cautious and there are less opportunities to take advantage of this herd mentality.
One of the key aspects of momentum investing is to be able to tap into this bullish emotion that can become visible on technical charts. Large number of traders that act on their emotions (e.g. fear, exuberance, hope, etc.) can put enough pressure on the stock price to propel it in a certain direction.
The goal of a momentum investor is to monitor the “pulse” of the market, follow the news that can create such emotional reactions, identify a trend produced by other investors, piggyback existing momentum and profit from bullish sentiment.
Successful momentum investing requires strict adherence to a set of rules to limit risk exposure and maximise profits. These rules do not prescribe which stocks to buy or sell, or which levels are most advantageous for trading momentum. Instead, their purpose is to instil a mindset of discipline that is critical to shorter-term momentum traders compared to longer-term buy-and-hold investors.
Before entering any trend-following trade, investors need to be certain that the opportunity actually exists. They wait for evidence of momentum to show itself as an already developed trend instead of anticipating it. They watch candlestick patterns and their movement closely. If the share price keeps testing a resistance level, but always pulls back, it could mean imminent trend reversal.
As momentum grows and a position becomes profitable, it is necessary to adjust stop-loss levels to protect profits (not too close, but not too far either). If the trend suddenly turns, tighter stop-loss will help retain gains.
The rule of thumb is to always allow the profits to run, but investors shouldn’t let momentum completely exhaust itself. If momentum starts weakening, it is safer to exit the trade ahead of the general crowd instead of waiting to gain an extra decimal point of profits.
Special attention needs to be given to proper timing of trade entry and exit. When trading momentum stocks, the most advantageous entry timing would be when sudden news story touches off share price movement and dislodges the stock from one support or resistance level to another.
This means that momentum traders need to closely follow corporate and global events to anticipate potential impact stories. The goal of this monitoring is not to better understand the company’s fundamentals, but rather to predict which stories can create the most intense emotional reaction from the market which in turn would drive share price momentum. The same is partially true for timing the exit from the stock. A sudden news story can stop and reverse a trend, but trends can also exhaust themselves when hitting a major resistance or support level.
When looking for momentum opportunities, it is preferable to invest in securities with plenty of liquidity. These include either popular stocks with large traded volumes, or “hot” stocks that have attracted intense public interest due to being in the news or offering a unique product.
Investors need to be aware that seasonal patterns can affect traded volumes, with summer months and holiday periods typically having higher volatility and price uncertainty. Since momentum investing concerns itself with price movements and direction rather than underlying company worth, it is better to avoid periods when prices can move erratically due to low volumes.
Instead of trying to “pick” stocks based on their fundamental value, momentum investors seek to “piggyback” an already existing trend. Thus, the art of momentum investing lies in spotting developed trends early to get the greatest rewards with the least risk.