Most human beings tend to go with the flow. People like to wear, eat and do what is trending. When investors adopt this ‘riding the trend’ strategy in the market, it is known as momentum investing. Momentum investing involves taking action according to market direction i.e. buying when the market is going up and selling when it is falling. To understand momentum investing, you must first understand what market momentum is.
This article guides the readers on market momentum meaning, market momentum indicators, and how it is useful.
Market Momentum
Momentum refers to the pace of security price changes. Market momentum means the acceleration rate of price movement of the overall market. Momentum has a positive correlation with the volume traded. Consequently, market momentum is a result of substantial trading volume in the market during a particular period. It reflects the ability of the market to sustain the trend during a particular time frame.
Market momentum shows the psychology of traders. Those involved in Momentum trading assume that the trend, whether upward or downward, will continue for a considerable time. This implies that if a security has a higher trading volume and continues to rise in price, other investors are attracted to it. When more stocks in the market see a price rise, more investors get attracted to the market and the momentum is generated. FOMO – Fear Of Missing Out plays an important role in creating momentum.
Investors /Traders can use market momentum to create an investment/trading strategies. Furthermore, momentum gives an idea of potential price movements. Generally, technical traders use a 10-day timeframe to measure market momentum.
To calculate market momentum, traders can use the following equation.
M = V – Vx
Here, M = market momentum
V = Current/latest security/index price
Vx = The closing price before n number of days
Momentum can be better understood by creating a trendline with different periods on the charts using this equation.
Example of market momentum
The Nifty 50 index is trading at 16700. The closing price before 10 days was 16150. The market momentum can be calculated as follows.
M = 16700-16150
= 550
This way momentum can be calculated considering different timelines to get a more accurate idea. Here traders believe that the trend will continue further. More interest from the traders keeps pushing the prices up.
Momentum is an important factor that NSE indices have created an index on momentum i.e. the ‘Nifty 200 Momentum 30 Index’. This index tracks the performance of the top 30 high momentum stocks of the Nifty 200. It is rebalanced semi-annually depending on the price performance of stock.
Market Momentum Indicators
Momentum indicators are the tools used to measure the rate of momentum. They give a more accurate idea of the market momentum. Some of the market momentum indicators are Market Momentum Indexes, Relative Strength Index (RSI), Moving Average Convergence Divergence (MACD), and Average Directional Index.
- Market Momentum Indexes: Momentum indexes were introduced by two companies, namely MSCI and FTSE Rusell. Traders can use MSCI USA Momentum Index, MSCI World Index, Russell 1000 Momentum Focused Factor Index, SPDR Russell 1000 Momentum Focus ETF, and so on, to check momentum scores.
- Relative Strength Index: RSI is a popular oscillator used to indicate upward and downward price momentum. The maximum and minimum values of the RSI indicator are 100 and 0 respectively. RSI above 70 signifies an overbought area, whereas below 30 reflects an oversold area. It guides the traders on the trend strength and indicates potential reversals.
- Moving Average Convergence Divergence: MACD is another useful oscillator. It states the relationship between two moving averages of the price of securities. You can calculate the MACD by subtracting the 26-period exponentially weighted moving average from the 12-period exponentially weighted moving average. The MACD line is obtained from this calculation. Next, the signal line, which is the nine-day EMA of the MACD, is plotted on the MACD line. Traders use this as a ‘buy’ or ‘sell’ signal.
- Average Directional Index: ADX is another trend-following indicator guiding the traders on whether to go long or short. The ADX reflects an uptrend or downtrend using two accompanying indicators, namely a negative directional indicator ( -DI) and a positive directional indicator (+DI). Thus, ADX guides the traders on trend direction and strength.
How is momentum useful?
Momentum signifies the trend strength/weakness and trend direction. Market momentum shows the strength and direction of the overall market. A positive momentum indicates an upward trend and reflects the betterness of security or the market. The reason is positive momentum can be the result of growing sales, and revenue or reducing debt, and so on. The bearish trend is signalled by a negative momentum which can be the result of the inferiority of security or the market.
Market momentum reflects the market behaviour. It guides the traders on whether to buy or sell. Momentum traders trust the strength of the trend and ride along. Instead of buying lower and selling higher, the momentum traders believe in buying when prices are going up and selling even higher. However, momentum is a technical indicator useful for the short term.
To wrap up, market momentum is one of the important ingredients of technical analysis that indicates the rate of velocity of the overall market. Market momentum is the result of high trading volume and growing prices. Traders believing in the strength of the trend invest in the market index going up, aiming to sell it higher.
There exist various momentum indicators. Though, relying solely on momentum indicators to make a trading strategy is not a good idea. Using these indicators in conjunction with other indicators can help traders make an effective trading strategy.
