The trend is your friend: How momentum beats market timing

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Momentum trading is a popular strategy in financial markets based on the belief that "the trend is your friend." This approach involves capitalising on the continuation of an existing price trend rather than trying to predict market direction.

This trading strategy, which is often use when investing in stocks, involves utilising indicators to ride the wave of a trend. Traders aim to enter positions when the momentum is strong and exit when the momentum weakens or shows signs of reversal.

The life cycle of a price trend typically consists of three stages: underreaction, overreaction, and convergence to fundamental value. Let's break down each stage based on the provided information:

Stage 1: Underreaction

In this stage, positive news gradually spreads among news watchers, market participants who react solely to news events. News watchers buy the asset based on the good news, believing it increases its fundamental value. Initially, the price remains relatively stable due to underreaction by market participants. However, the price slowly rises over time as the market incorporates the latest information.

Stage 2: Overreaction

Momentum traders start noticing the slow uptrend in the asset's price and decide to join in, buying the asset and pushing the momentum further. The increased participation from traders causes the price to overshoot above the asset's fundamental value.

Stage 3: Convergence to fundamental value is the final stage.

The market fully comprehends the news that initially sparked the trend. As a result, the uptrend begins to reverse, and the price gradually aligns with the asset's fundamental value. Traders who entered early in the trend may start taking profits, leading to a slowdown in momentum. This stage often exhibits increased volatility, and technical indicators may indicate overbought or oversold conditions.

A good example that shows this life cycle was the value of Bitcoin between 2017 and 2018.

Momentum trading incorporates the use of various indicators and tools used to identify trends. These tools include:

Moving average

Moving average is used to indicate price trends over short and long periods. Traders use different timeframes of moving averages, such as the 50-day and 200-day moving averages, to identify the overall trend direction. Crossovers between different moving averages can also signal potential entry or exit points.

Relative Strength Index (RSI)

RSI is a popular oscillator that is used to measure the momentum of price movements. It helps traders identify overbought or oversold conditions in an asset. RSI values above 70 typically indicate overbought territory, while values below 30 suggest oversold conditions.

Stochastic Oscillator

This oscillator compares an asset's most recent closing price to those over a specified period. Note that the trend is positive when the closing price is near the high of the price range for the time period, and when the closing price is near the low, this indicates a downward trend.

Momentum stocks exhibit significant price appreciation or depreciation over a relatively short period. They are characterised by strong market interest and often attract attention due to their growth potential or market sentiment.

Tesla (TSLA) and Apple (AAPL) have been momentum stocks due to substantial hype before product announcements or key events. This hype drives significant price movements as traders and investors anticipate positive outcomes. Media coverage, investor sentiment, and market expectations fuel this momentum. For example, Tesla's product unveilings, like new vehicle models or advancements in autonomous driving, attract attention and drive up the stock price. Similarly, Apple's product launches, such as new iPhone models, generate momentum, increasing buying interest and price appreciation.

Momentum trading is a popular strategy focusing on capitalising on existing price trends rather than predicting market direction. Traders utilise indicators to ride the wave of a trend, entering positions when momentum is strong and exiting when it weakens or shows signs of reversal. Stocks like Tesla (TSLA) and Apple (AAPL) have been considered momentum stocks due to substantial hype surrounding their product announcements and key events.