How to identify momentum stocks?
You must be aware of the fact that in order to get good returns, you need to stay invested in the stock market for the long-term. There exists another methodology which involves frequent buying and selling of shares on the basis of certain indicators, known as momentum investing. In this article, we will understand what momentum investing is and how an investor can identify momentum stocks.
Let’s understand what is momentum investing
Momentum investing involves buying and selling stocks which are likely to witness a substantial appreciation in prices within a short period of time. The main idea is to capitalize on existing trends in the market.
This methodology is equivalent to riding a wave. You try to identify a stock whose price will climb up due to the increased trading activities of investors driven by factors like market sentiment which generates momentum. You ride this wave until the momentum of this stock peaks and before it starts to subside you cash out, earning a good profit. All of this happens in a short time-frame, usually a few months or even weeks.
All you’re doing is exploiting the herd mentality, as traders tend to rally behind stocks that will turn bullish and hopefully pull out at the right time so that they probably get better returns.
Higher volatility holds the potential to yield probably better returns if you buy in and cash out at precise times. And as easy it is to earn profits; it is equally easy to lose money due to bad timing or a miscalculation. So, it’s a high-risk scenario.
Now in order to capitalize on such trends in the market, you need to be able to spot such stocks and then determine the momentum associated with them according to which you will buy or sell the stocks.
There exist certain indicators which aid investors in determining the momentum. Let’s go through them one by one.
Firstly, let’s cover the trading volume
Trading volume represents the trading activity around the stock. Generally, stocks which are supported by high trading volumes signal higher interests in the stock, which indicates a rise in momentum and lower trading volumes signal a lack of interest which translates to a lack of momentum. As we are talking about exploiting the momentum, you should ideally buy in at a time when the stocks are rising with higher volumes and sell out when you see them falling with higher volumes.
Secondly, let’s deal with the RSI indicator
The RSI, or the Relative Strength Indicator measures the change in price and the speed with which such changes are taking place. The range within which the RSI oscillates is from 0 to 100. A stock is considered to be overbought when RSI levels go above 70 and a stock is considered to be oversold when RSI levels dip below 30. RSI levels going above 70 indicates that the stock is losing momentum and you should consider selling your position. If RSI levels dip below 30, the stock stands to gain momentum and you may consider buying in.
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Thirdly, let’s come to the RoC oscillator
The RoC oscillator or the Rate of Change Oscillator gauges the speed with which the stock price is changing within a certain timeframe. It is calculated as the percentage change between the latest stock price and the price that existed ‘n-periods’ ago. The RoC oscillator fluctuates above and below zero. RoC value greater than zero reflects an upward momentum, associated with a sharp uptick in price, and a RoC value lesser than zero signals an increase in the downward pressure, associated with a sudden drop in price. The movement of a stock crossing the zero line is considered as a trend change signal.
And finally, let’s cover the ADX indicator
The Average Directional Index, or the ADX indicator consists of the minus directional index -DI and the plus directional index +DI. This indicator is used to estimate the strength of the price trends both in the positive and the negative direction. ADX values higher than 20 indicate the presence of a trend in the market and ADX values lower than 20 indicate that there is no substantial trend present and the market is relatively directionless.
Volatility is the entire premise of momentum trading, the principle of buying low and selling high. Thus, you should seek volatile markets to find the right moment to buy in and subsequently cash out, as the crests and troughs hold the potential to probably yield better returns.
But as momentum trading is inherently risky, risk management strategies like setting stop loss limits should be implemented so that you don’t end up losing your money.
The bottom line is that none of these indicators work reliably if used in isolation. All these indicators should be used in unison to be confident of your buy and sell positions and possibly earn better returns.
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To conclude, let’s summarize everything we discussed:
- The main objective of momentum investing is to capitalize on trends in the market by buying and selling stocks which are likely to witness a substantial appreciation in prices within a short amount of time. There are certain indicators which can help you in identifying momentum stocks.
- Trading volume represents the trading activity around the stock. High trading volumes indicate rise in momentum and low trading volumes indicate a lack of momentum but you should also identify the direction of the momentum.
- Then we discussed indicators like the relative strength indicator, rate of change oscillator and the average directional index, all of which are instrumental in assessing the momentum associated with a stock.
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