14. Price Momentum Strategy

Published at 1651764044.808

What Is Momentum?

In the stock market, stock prices always change due to the impact of supply and demand. When demand is greater than supply, the price starts to increase, and vice versa. There are several reasons why supply and demand are always changing. Common ones include positive macro impacts, good business news, and cash flows from new investors. These fundamentals give the stock incentive to rise in the beginning when demand outweighs supply.

Investment analysts observe that once a stock starts to rise, the bullish momentum will continue to stay the same for a certain period of time before stopping or turning bearish. This process is similar to throwing a coin vertically into the air. When the initial force is stronger than the earth’s gravity, the coin begins to accelerate and move upwards in the first few seconds. With momentum, the coin continues for another period with decreased speed before falling down. This analogy leads to a common term in physics “momentum” to be applied to finance.

Price momentum in finance is the rate of increase/decrease in a security’s price over a period of time. It’s also known as the rate of price change and is used to measure the strength of a trend.

In algorithmic trading, the momentum strategy buys rising stocks and short-sells falling stocks. It argues that stocks tend to keep following the trend in the short term. This argument comes from the belief that once the trend is established and there is sufficient momentum, it will continue to last a brief period of time for scalping to take profits.

In short, the main purpose is to buy stocks when the price has risen and sell when the price rises even more. Buy high and sell higher. The opposite of this strategy is the mean-reversion strategy. It buys stocks that are too low compared to their intrinsic value, or average value, and vice versa. Buy low and sell high. This strategy will be discussed in the next article.

Causes of the Momentum Effect 

There are two plausible explanations for this effect. The first comes from studies of behavioral finance related to investor biases. Investors often overreact to information and events, leading to an increase in strength and prolonging trends.

The second is that investors receive and process information at different reaction times. When there’s a positive event, early investors realize the potential of the stock and start buying. It initiates the price trend to start moving upward. Some other investors slowly realize the opportunity but still have high expectations and decide to buy at a higher price. They maintain the uptrend. Both have positive expectations but different action timing, resulting in an uptrend that may last for a brief period of time before stopping and reversing.

Investment Risks in the Price Momentum Strategy

This trading strategy works on a basic assumption: when a trend appears, it will last for a sufficient period of time to take profits from corresponding positions. However, in practice, there’s no guarantee this assumption always holds true.

Daily events and news directly affect investor psychology and expectations. They create changes in supply and demand, initiating trends. However, at the same time, investor sentiment also changes unpredictably during this brief period. A newly started uptrend can be short-lived when later macroeconomic news negatively impacts investors’ sentiment in the whole market.