Why buying stocks on momentum makes perfect sense

Day traders and short-term investors do not get the best press despite the fact that they have a significant impact on market liquidity. Often accused of dealing on inside information or with preferential knowledge they attract unwanted attention. However, many short-term investors simply buy stocks on momentum and more often than not they will see a return. So, why does buying stocks on momentum make perfect sense?

See the stock market as an information exchange

If you take a step back and look at worldwide stock markets as “information exchanges” you may be able to appreciate why momentum buying is often successful. The price of any asset, whether a share, bond or precious metal is dictated by information which is in the public domain and also information which is shielded from the general public – i.e. inside information. Whether the regulators like it or not, the price of a share is dictated by an array of information some of which is legal and some of which is not.

Momentum trading
Why buying stocks on momentum makes perfect sense

Let’s be honest, how many times have you seen a share price move prior to an announcement? This may be a positive or negative announcement but very often the share price indicates something is happening. All you need to do is learn to read the signs!

Professional traders

Professional traders will have their own sources for information and indeed they will watch an array of different stocks extremely closely. This is how many of them are able to spot momentum shares at a relatively early stage so that they can enjoy much of the ride upwards. There is an old saying in the stock market, “It is better to travel than arrive”, which basically means buy on rumour and sell on fact.

If you consider this, it will start to make perfect sense because once the share price begins to gather momentum investors, with an array of levels of information, will begin to chase the share price. When the share price is gathering momentum the ever-increasing number of investors wanting to jump on board can push prices way beyond the fair value level even if good news is on the way. Before the expected “good news” is announced there will be rumours of good figures, takeover talks, etc which will give different possible valuations of the company. It is only when the actual announcement is released, assuming the momentum indicators were right, that investors can begin to value the company on real information.

Profit-taking

Again, if you follow stock markets you will be well aware that some shares have a run ahead of figures or an important announcement and then once the information is in the public domain the profit takers will take over. A share which has been in demand can very quickly be overrun by sellers losing momentum, turning down and prompting many short-term investors to ditch their holdings and move onto the next momentum play.

Momentum also works on the downside

While the majority of investors tend to look at positive share price movements the idea of momentum trading also works on the downside. If there are disappointing figures due from a company, perhaps takeover talks have ended or some other information detrimental to the future of the group is in the offing, a weak share price will often indicate this well in advance of the official announcement. These are situations when some investors will “short stocks” which effectively means selling shares they don’t own and then buying them back lower down when the share price falls. Again, while many investors and some regulators will see this as detrimental to the performance and the validity of stock markets it does help with liquidity. The simple fact is that if those “short selling” are wrong and the share price moves higher then they will be forced to close their positions by buying back shares at a higher price – thereby crystallising potentially significant losses.

Conclusion

Quotes such as “The trend is your friend”, “Listen to what the share price is telling you?” and “Momentum should not be underestimated” would be ignored at your peril. At the end of the day, investment markets are simply investment exchanges where different views and opinions are added to the mix prompting share prices to fall, remain static or move ahead.

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