Today's stock market is more than just a place to buy and hold securities. Many investors prefer to move quickly in and out of the market. That's just one reason technical strategies, such as price momentum, have grown in popularity.
In this article, we're going to provide some insights into the investment strategy known as price momentum. We'll explain why some theorists believe this model offers investors a short-term profit opportunity. We'll also talk about the pros and cons of this approach, including the long-term opportunity that price momentum provides the market.
What is Price Momentum?
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The theory behind price momentum is relatively simple. Generally, we can talk about it in two ways; the first has to do with buying stocks:
Stocks that had relatively high returns over the past three to twelve months should return to investors above average returns over the next three to twelve months.
The theory also provides guidance on the right time to sell stocks:
Stocks that had relatively poor returns over the past three to twelve months should return to investors below average returns over the next three to twelve months.
This investment strategy was first theorized by Narasimhan Jegadeesh and Sheridan Titman in their publication "Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency," which was published in The Journal of Finance back in March 1993.
Price Momentum Model
The model is based on the assumption the stock market is not completely efficient. This is something that most economists believe to be true. The two most practical explanations for the performance of this model include:
Investors are taking advantage of human behavior, including a "herding" mentality and / or an overreaction to news.
Investors employing a price momentum strategy are taking on additional risk; therefore, higher returns are required to compensate these investors for the risk they're assuming.
Within their study, Jegadeesh and Titman examined a large number of trading strategies. One of the conclusions from that study is stated below:
Buying past winners, and selling past losers, allowed investors to achieve above average returns over the period 1956 to 1989. In particular, stocks that were classified based on their prior 6-month performance, and held for 6 months realized an excess return of over 12% per year on average.
The Momentum Formula
Technical stock analysts understand the value this particular technique provides. They're constantly crunching numbers to see if patterns emerge. The actual formula for calculating price momentum is really quite simple, and takes the form:
M = CP - CPn
Where:
M = Momentum
CP = Closing price in the current period
CPn = Closing price N periods ago
For example, if a stock was trading at $35 per share six months ago, and is currently trading at $40 per share, then its six-month price momentum would be 40 minus 35 or 5.
Unfortunately, this formula is not normalized, and this makes it difficult to compare stocks selling at different price points. A stock experiencing a 1% price movement from $300 to $303 would have a momentum value of three. A second stock experiencing a 100% increase in price from $3 to $6 also has a momentum value of three.
Rate of Change Formula
One of the ways technical stock analysts can work around this problem is by calculating a rate of change value, which normalizes momentum:
RoC = (CP - CPn) / CPn
Where:
RoC = Rate of Change
CP = Closing price in the current period
CPn = Closing price N periods ago
Using the example above, the stock selling at $303 per share that was trading at $300 six months ago would have a Rate of Change of 3 / 300 or 1%, while the second stock would have a Rate of Change of 3 / 3 or 100%.
Momentum and Moving Averages
A second way that stock analysts use price momentum is in conjunction with moving averages. Here the technical analyst makes a series of price momentum calculations and plots these along with a moving average of the momentum.
For example, the plot might contain 28-day moving averages along with daily price momentum figures. Buy signals can be triggered when price momentum travels above its moving averages, and stays there for several trading days. Sell signals can be triggered when momentum travels below its moving average.
Contrarian Investing
As mentioned in the beginning of this article, this model tells investors they should buy past winners and sell past losers. Because this theory is based on past price performance, or historical market information, price momentum is a trading model that technical analysts would follow. Fundamental analysts believe that a stock is bought and sold based on its intrinsic value, including the company's potential to produce profits for its shareholders in the future.
Fortunately, fundamental analysts can also use price momentum to their advantage by adopting what is termed a contrarian investing strategy. Contrarian investors take the opposite approach that a theory advocates. For example, a fundamental analyst might conclude:
A stock that has been rising may now be overvalued, while a stock that has been falling may be undervalued.
One could argue the further a stock moves from its true market value, the greater the opportunity for profits. By tracking price momentum, and using this as a screening tool, fundamental analysts can then assess if a stock is truly undervalued or overvalued by studying the company's long-term financial health and earnings power.
About the Author - Understanding Price Momentum
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