Momentum trading is essentially a popularity contest. A stock can increase in value because it delivers consistent growing profits or because everyone believes in ‘the story’. Just because everyone is wrong in buying a share does not mean you cannot make money from it. Sometimes following a crowd is a good thing, but learn to do so whilst protecting yourself.
What is momentum trading
Why you should take advantage of it
The pitfalls to avoid
Momentum trading is a strategy where investors seek to follow stocks which are trending in a particular direction. This is usually upwards, but for a hedge fund manager this can also mean shares which are losing value.
Essentially you are choosing the follow the herd, whose constant buying will create a momentum in a share(s). This can lead to a market rally being created.
A stock which has a large number of shares being traded every day, is in the news and corresponds to thematic investing ideals will typically be one to display upwards momentum. A recent example of of share with momentum behind it, is Tesla stock.
Just because a stock is low risk with good financials may not lead to share price gains – this is where having a ‘feel’ for the market is important. Fundamentally, it is a beauty parade… a stock which appears to offer the greater chance of making an investor money, will often outperform.
A stock can shoot upwards with poor financials due to savvy marketing by its board, or because a generation of young impressionable and uninformed novice traders, support the concept the company is pedaling. Many renewable energy and electric car stocks spring to mind.
Stock market darlings with strong momentum can also be in the process of creative accounting. The Wirecard debacle should be a warning to all. If a stock you own is caught in the cross hairs of negative press or a short-seller, it is often best to reduce your position and lessen the risk.
You win both ways in this manner. If the stock recovers you have not lost out, but if it plunges in value you have saved some of your capital. Capital preservation is an often undervalued part of investing, and reduces downside risk.
An example of momentum trading that you should avoid is Reddit day trading. When it hit the headlines in early 2021, the overnight increase in the #WallStreetBets group showed how powerful momentum can be. As the GameStop shares jumped higher, many got sucked in.
The problem is many novice traders did not understand the risks of the most volatile stocks. Failure to understand an investment case should be a red flag. If they did, they would have realised that when the tide turned, the shares would crash and they would lose most of their money.
When such an episode happens again, and it will in a different form in the future, you should watch and learn. This way you can see the downside of momentum and learn to ignore the novice trader’s belief that ‘it will not happen to me’. No-one ever lost money by sitting on their cash.
Investing in renewable energy is fashionable in the current political climate. Many retail investors are quick to buy into it, as they also see their capital as a chance to make a positive difference. Yet this desire must take into account reality. Wind farm companies are seeing their margins drop… yet shares are going higher. As a result their share prices can get ahead of their financials which leads to overvalued stocks. When a sell off occurs, investors will punish these momentum stocks. Furthermore, BP and have other large energy companies who have missed the ‘green’ boat, are trying to catch up and in the process creating value destroying bidding wars.
Green energy firms cannot compete with big energy groups.
Indeed many companies in the renewable space are former utility companies which have re-branded themselves as renewable energy ones. Utilities have never been known as growth stocks, but as income focused ones. Therefore check a share’s history before jumping in.
Be careful of the’green’ momentum, as many stocks in this space are hot stocks. The recent volatility in price of the iShares global clean energy ETF has highlighted how momentum can change direction violently.
On balance momentum trading is good, as it pushes shares higher. Where momentum trading can be a problem is when human emotions affect judgement. If a share such as Tesla stock is shooting upwards, you may be tempted to join in because of the ‘fear of missing out’.
This is not a valid reason to buy in. If the urge is too great, only take a small position: maximum 2% of your portfolio. In this way you limit your losses if you bought in too late. Another way of protecting yourself is to ignore momentum altogether, and seek to open positions in a sector that no-one else is touching, such as a contrarian investor would.
We have seen some large momentum trading moves over the past 12 months. It started with the big tech stocks after the March 2020 sell off, moved into the clean energy listed company space in the early autumn of 2020, before another sector rotation into emerging markets over the end of 2020 and start of 2021.
This demonstrates the power of momentum but also the difficulty. Were you able to spot any of these trends before they occurred? Holding a diversified stock portfolio will insure that you can benefit from both exposure to any trend that gets caught up by momentum trading, whilst enjoying the protection that diversification gives you.