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Understand what momentum investing is and how it functions. Check out why it has become increasingly relevant among investors today.
Momentum investing has gained popularity among retail and institutional investors in recent years. It is a strategy that seeks to capitalise on the continuation of existing market trends. By mastering this approach, you can rely on data and behavioural psychology to identify opportunities for growth.
A momentum investing strategy seeks to profit from continuous upward or downward trends. It involves buying securities that exhibit an upward price trend and selling those with a downward trend.
The core principle is the tendency of assets that are rising in price to continue rising, and vice versa, at least in the short to medium term.
Unlike value investing, momentum investing focuses on the strength of price movements. It relies on technical indicators to identify securities showing strong performance.
The concept of momentum investing originated in the 19th century with Charles Dow. He noticed that stocks tend to move in trends, as those rising in price often continued to rise, while those falling continued to decline. This insight evolved into the concept of momentum strategy.
In the 1990s, researchers like Jagdeesh and Titman further validated this strategy. Their research indicated that momentum may reflect a persistent market anomaly stemming from investor behaviour.
As the strategy matured, it evolved into more refined models, such as cross-sectional momentum. Here, investors target stocks outperforming their sector or market peers.
In India, this evolution is represented by the Nifty 200 Momentum 30 Index, launched in 2020 with a base date of April 1, 2005. The index selects the top 30 companies from the Nifty 200 based on their 6–12-month price performance, adjusted for volatility.
It employs a data-driven approach to identify patterns that suggest a security is likely to continue on its current trend. The strategy is primarily based on:
1. Price Strength: The premise is that securities that have recently increased in price are likely to continue gaining and vice versa.
2. Volume Confirmation: Higher trading volume accompanying price increases are considered to be a signal of strong momentum.
3. Trend Duration: Momentum strategies often consider performance over a lookback period, typically of 3, 6, or 12 months.
Technical indicators play a crucial role in momentum analysis. They help you identify the strength and direction of a price trend. They also provide signals for entry and exit points based on price movement and market sentiment.
Here are a few commonly used indicators:
Relative Strength Index (RSI): Measures recent gains against recent losses; RSI above 70 often indicates overbought conditions
Moving Averages (MA): Both Simple Moving Average (SMA) and Exponential Moving Average (EMA) are used to track trend direction
Moving Average Convergence Divergence (MACD): Helps identify changes in momentum by comparing two EMAs
Rate of Change (ROC): Percentage change in price over a given period
Rate of Change, ROC (%) = [(Current Price - Price ‘n’ periods ago) / Price ‘n’ periods ago] x 100
A sustained positive ROC indicates upward momentum and vice versa.
This strategy has become popular due to a confluence of behavioural, technological, and market structure factors. Check these details below:
You, as a retail investor, have access to real-time charting tools and apps, levelling the playing field.
Various platforms on social media and online communities have forums where short-term trends are discussed and are easy to access.
Markets have exhibited high short-term volatility, giving rise to clear momentum patterns.
Exchanges and Asset Management Companies (AMCs) now offer products such as momentum-based ETFs and indices. These products track high-momentum stocks, bringing the concept into mainstream investing.
Relative Strength Index (RSI):
Measures the magnitude of recent price changes to evaluate overbought or oversold conditions, typically on a scale of 0 to 100.
Moving Average Convergence Divergence (MACD):
Shows the relationship between two moving averages of a stock’s price and helps identify changes in momentum and trend direction.
Rate of Change (ROC):
Calculates the percentage change in price over a specific period to determine how quickly a stock’s price is moving.
Stochastic Oscillator:
Compares a security’s closing price to its price range over a set period, helping detect trend reversals and momentum shifts.
Volume Indicators (e.g., On-Balance Volume - OBV):
Analyze trading volume to confirm the strength of a price trend, as rising prices backed by high volume suggest stronger momentum.
Market momentum measures the rate of acceleration of a security's price or volume. It helps traders assess the strength of a price trend. The basic formula for calculating momentum is:
Momentum = Current Price – Price n Periods Ago
Where n is the number of time periods (e.g., days, weeks) over which the momentum is measured.
A positive value indicates upward momentum, while a negative value suggests downward momentum. This indicator is often used alongside other technical tools to confirm trend strength and potential reversals.
While a momentum investing strategy offers potential benefits, it also comes with its risks. Be mindful of the following:
Reversal Risk: Trends can reverse due to market corrections, macro events, or company-specific news
High Turnover: Frequent buying and selling lead to increased brokerage and transaction costs
Tax Implications: Short-term capital gains may apply due to the low holding period
Psychological Traps: Overconfidence can lead to chasing trends without understanding fundamentals
Momentum investing has found a legitimate place in modern portfolio construction:
Quantitative Models: Many hedge funds and institutional investors incorporate momentum signals.
Index Providers: NSE’s Nifty 200 Momentum 30 index is a live example where the top 30 stocks with the highest momentum are selected. They are based on 6-month and 12-month returns.
Mutual Funds/ETFs: Some AMCs launched passive momentum funds tracking such indices. They offer exposure to this strategy without active stock-picking.
Momentum investing offers you a way to participate in short-term market trends. However, it requires careful monitoring, disciplined execution, and awareness of potential reversals.
This content is for informational purposes only and the same should not be construed as investment advice. Bajaj Finserv Direct Limited shall not be liable or responsible for any investment decision that you may take based on this content.
Sources
https://www.sebi.gov.in
https://www.nseindia.com
https://corporatefinanceinstitute.com
https://www.investopedia.com
https://papers.ssrn.com (Jegadeesh & Titman 1993)
https://www.livemint.com/money/personal-finance/momentum-investing-what-is-it-and-what-are-its-pros-and-cons-an-explainer-11707740406876.html
https://www.etmoney.com/learn/stocks/know-about-momentum-investing/
https://cleartax.in/s/momentum-indicator
https://cleartax.in/s/momentum-indicator
https://www.business-standard.com/finance/personal-finance/momentum-funds-invest-if-you-have-long-horizon-stomach-for-volatility-125022700809_1.html
Momentum investing is a strategy that focuses on buying stocks that are rising and selling those that are falling. They are based on short-term trends.
Yes. It involves technical indicators such as RSI, MACD, and moving averages to identify entry and exit signals.
Momentum investing focuses on short- to medium-term price trends. On the other hand, long-term investing is based on fundamentals and long-duration holding.
Yes, but it requires an understanding of technical indicators and disciplined risk management. Thematic ETFs make this accessible to retail participants.
Yes. For example, the Nifty 200 Momentum 30 Index tracks stocks that exhibit strong relative performance.
