Momentum investing is a sharp contrast to typical long-term investing. Specifically, it focuses on short-term volatility, timing peaks and valleys of the security, and relevant market sentiment to generate returns. This type of investing is done with an eye on volatility and far less on underlying fundamentals, long-term trends, dividends, or balance sheet considerations. Here we will go over the basics of momentum investing.
Every time someone buys or sells on the market, two variables inevitably increase cost and decrease returns: trading fees and bid-ask spread. Trading fees are specified by the broker that executes a trade and must be taken into consideration when trading securities on momentum. Some brokers reduce or eliminate fees when certain trading or account specifications are met. Those types of discounts can work wonders for overall return from momentum investing since even small fees add up quick when trading momentum.
Bid-ask spreads are another facet of life and, unlike fees, cannot be negotiated. Bid-ask spreads are very narrow for popular and large-volume securities like mega-cap stocks or trusted currencies like the US dollar and the Euro. Obscure securities like nano-cap stocks or currencies issued by financial unstable countries have a much larger bid-ask spread.
Momentum vs. Fees and Spreads:
When trading momentum, an investor has to make a decision based on the following fact: volatility is a friend, and smaller securities can offer incredible volatility and potential for great returns. Is the larger bid-ask spread worth the volatility? Could I generate large enough returns consistently enough to overcome the substantially higher cost basis that comes with large spread? If not, momentum trading should be done extremely cautiously, if at all.
Greed and Fear:
A momentum investor has to be tuned into timing the scope of greed or fear that other large traders have regarding his security of interest. Market psychology is hardly rational in the short term in the sense that price doesn’t always reflect value; hence “overvalued” and “undervalued” parlance among traders. As such, entry and exit points can be anticipated with some success using technical indicators that, to some extent, quantify greed and fear relative to past price, volume, volatility, and other data. Executing trades quickly is critical when trading from the volatility generated by greed or fear.
Momentum trading is a strong contrast to the slow-and-steady-wins-the-race approach. It is based on identifying entry and exit points indicated by past experience, technical indicators, and some degree of intuition about market psychology. Though volatility is sometimes perceived to be risky, a momentum investor can only make profits from volatile securities. Otherwise, trading fees and bid-ask spread eat up too much of the profit margin and increase losses past the point of compensating for the risk and expertise it takes to trade on momentum.
Edward Schinik has been with the Investment Manager since 2009 and has been with one Affiliated Investment Manager since 2005.