Momentum is the rate of acceleration of a security’s price or volume. In technical analysis, momentum is considered an oscillator and is used to help identify trend lines.
In general, momentum refers to the force or speed of movement; it is usually defined as a rate. In the world of investments, momentum refers to the rate of change on price movements for a particular asset – that is, the speed at which the price is changing.
Once a momentum trader sees acceleration in a stock’s price, earnings or revenues, the trader will often take a long or short position in the stock in the hope that its momentum will continue in either an upward or downward direction. This strategy relies on short-term movements in a stock’s price rather than fundamental value.
If a trader wants to use a momentum-based strategy, he takes a long position in a stock or asset that has been trending up. If the stock is trending down, he takes a short position. Instead of the traditional philosophy of trading – buy low, sell high – momentum investing seeks to sell low and buy lower, or buy high and sell higher. Instead of identifying the continuation or reversal pattern, momentum investors focus on the trend created by the most recent price break.
Think of it like the momentum of a train. When a train starts, it is accelerating, but it is moving slowly. In the middle of the trip, it stops accelerating, but it is traveling at a higher velocity. At the end of the trip, the train is decelerating as it begins to move slower. For the momentum investor, the best part of the train ride is in the middle, when the train is moving at its highest velocity.
Momentum investors like to chase performance. They attempt to achieve alpha returns by investing in stocks that are trending in one way or another. Stocks trending up are referred to as hot stocks. Some are hotter than others as measured by growth over a period of time. A stock that is trending down is cold.
Some tools for momentum investors help to define the trend, such as the trend line. A trend line is a line drawn from the high price to the low price, or vice versa, over a given time period. If the line is up, the trend is up and the momentum investor buys the stock. If the trend line is down, the trend is down and the momentum investor sells the stock. In this way, momentum investing is purely a technical indicator. Though the “momentum” can refer to fundamental measures of performance, such as revenue and earnings, it is most commonly used in reference to historical asset prices as a technical indicator.
A reversal is a change in the direction of a price trend, which can be a positive or negative change against the prevailing trend. On a price chart, reversals undergo a recognizable change in the price structure. A reversal is also referred to as a “trend reversal,” a “rally” or a “correction.”
An uptrend, which is a series of higher highs and higher lows, reverses into a downtrend by changing to a series of lower highs and lower lows. A downtrend, which is a series of lower highs and lower lows, reverses into an uptrend by changing to a series of higher highs and higher lows.
Reversals often occur in intraday trading and happen rather quickly, but they can also occur over days or weeks of trading. Technical analysts watch for reversal patterns throughout the day, because they can indicate the need for a different trading strategy on the same security or can provide an opportunity to profit. Intraday reversals are often the result of news events and company announcements that change the valuation outlook for a specific stock.
Potential Trading Strategies
By watching the technical charting of a stock’s price, traders can identify when a reversal is occurring. Traders often anticipate a reversal to occur in a stock that has been consecutively reaching new highs or new lows. In technical trading analysis, traders often closely watch the candlestick movements of a stock. In technical analysis, the candlestick represents the stock’s trading price range throughout the day, with the top being its highest price and the bottom being its lowest price. A candlestick chart shows the consecutive movement of the stock’s price throughout the day, with emphasis on its trading range.
Example of Trading Strategy
An example of a trading strategy for a stock reversal to the downside could occur when a technical analyst holds stock ABC and notices a reversal pattern in the candlestick charts. Technical analysts typically consider a reversal trading pattern reliable to trade upon after five to 10 consecutively lower candlestick patterns trading within approximately a five-minute timeframe. When this occurs, a trader seeking to profit on a reversal to the downside could close his existing long position and assume a short position, to capitalize on the downward movement of the stock’s price.
Given the opposite trading scenario, a technical analyst seeking to profit from a reversal to the upside would initiate the opposite strategy. If the trader sees adequate consecutive candlestick pattern movement to the upside after the stock’s price has been trending downward, the trader may assume a reversal and could then enter into long positions to benefit from the rising prices, and close out short positions to stop the investment from incurring further losses.