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.
"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.
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.
