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Thursday, August 19, 2010

Technical Analysis: Momentum Investing

Momentum investing is a system of buying stocks or other securities that have had high returns over recent times. The basic is if a stock is having a up momentum, price going up, it usually goes up more until one point. It has been reported that this strategy yields average returns of 1% per month for the following 3-12 months. Momentum investors try to seek out stocks with the potential to double or triple within just a few months.

You can see momentum investing was on the dot-com stocks. The prices of these stocks seemed to rise for no good reason, despite lack of earnings - or sometimes even the prospect of earnings. The price of the stock keep going up until it burst.

As momentum investors see a rising trend, they all join in, driving prices even higher. It may seem like a winning strategy, with the promise of high upside and limited downside. But the risk of this strategy is that, while momentum investors can all pile in at the same time, they cannot all sell at the same time unless markets are both highly liquid (easy to sell because many people want to buy) and continuous (prices do not gap sharply downward with no opportunity to sell).

When there is no good fundamental on the stock, it can go down very quickly. When a bad news comes out, previous buyers will try to get out. The stocks become highly illiquid and prices become discontinuous. This will drive prices lower and also leads to margin calls, and thus more selling. This happened when technology and dot-com bubbles burst in March 2000.

What do they look for in momentum investing?

Momentum investing usually looks for rapid earning growth or recent positive changes in earnings-growth forecasts. Earnings momentum starts with strong quarterly year-over-year earnings growth. Momentum investors also looks for a positive earnings surprise in the last reported quarter, meaning that the reported earnings exceeded the forecasts.

Momentum investing is not a buy-and-hold strategy. Momentum investors typically hold a stock for a few weeks / months. However, they usually monitor their holdings daily.

When to sell?

Momentum stocks get hammered when something goes wrong. Consequently, momentum investors must act quickly at the first sign of trouble. When there is bad news coming out, that's the sign to sell, especially when the price go down quickly with big volume.

Momentum investing is risky, and requires close attention and discipline. When price go down, think that it can go down further, not it can go up again.