MOMENTUM IN EQUITIES: DEFINITION AND KEY METRICS

Momentum in equities refers to the rate at which a stock's price is rising or falling. It is a widely observed market phenomenon based on the idea that assets which have performed well recently tend to continue performing well in the near term, while underperforming assets may continue to lag. Momentum is not just a psychological pattern; it is backed by empirical evidence and has become one of the core styles of investing employed by quantitative analysts and portfolio managers.

The principle is grounded in behavioural finance where investor herding and confirmation biases reinforce trends. Stocks that gain rapid popularity among investors since they are rising attract additional buyers, creating a self-fulfilling surge. Conversely, stocks in decline often continue falling as bearish sentiment builds. This pattern can persist until a major change in fundamentals or sentiment reverses the trend.

Momentum is closely associated with technical analysis, where past price and volume data are used to forecast future movements. It is used across various timeframes depending on the trader’s or investor’s goals—ranging from short-term strategies like day trading to long-term models used by institutional fund managers.

There are two broad types of momentum strategies:

• Absolute momentum: This strategy looks at an individual stock’s own past performance to forecast future returns, often comparing price levels over different time intervals.
• Relative momentum: This compares the performance of a stock against other stocks or an index to identify relative strength. Investors use this to rotate capital into sectors or assets that are outperforming peers.

While momentum can offer profitable opportunities, it carries risks. Trends can quickly reverse due to external shocks, manipulation, or mean-reversion forces. Successful participants typically combine momentum with risk controls, such as stop-loss orders or diversification.

Momentum in equities is quantified using various mathematical and analytical methods, with several well-established indicators in technical and quantitative investment disciplines. The simplest form of measuring momentum is based on price change over a defined period, often referred to as the rate of change (ROC). However, multiple tools and strategies have evolved for a nuanced assessment:

1. Rate of Change (ROC)

The ROC calculates the percentage change in stock price over a specific timeframe. The formula is:

ROC = [(Current Price - Price N periods ago) / Price N periods ago] * 100

For example, a 12-month ROC compares today’s price with that 12 months ago. A positive ROC implies upward momentum, and a negative one indicates downward momentum.

2. Moving Averages

Momentum investors often use simple moving averages (SMA) or exponential moving averages (EMA) to identify trends. A common approach is comparing short-term to long-term moving averages, such as a 50-day and a 200-day moving average. When the short-term average crosses above the long-term average (a ‘golden cross’), it signals potential bullish momentum.

3. Relative Strength Index (RSI)

The RSI is a momentum oscillator that measures the speed and change of price movements on a scale of 0 to 100. An RSI above 70 typically indicates overbought conditions, while an RSI below 30 suggests oversold status. The RSI helps spot potential reversals in overextended trends.

4. Moving Average Convergence Divergence (MACD)

The MACD indicator shows the relationship between two EMAs (typically 12-day and 26-day) and incorporates a signal line (usually 9-day EMA of MACD itself). When the MACD crosses above the signal line, it suggests upward momentum; when it falls below, it may indicate bearish momentum.

5. Momentum Score (Quantitative Models)

Institutional investors and quants often compute a standardised "momentum score" for stocks, incorporating multiple indicators like 3-month, 6-month, and 12-month total returns. The scores are used to rank securities and make model-based investment decisions.

These tools function most effectively when aligned with volume analysis, market context, or other confirming indicators. Importantly, most are backward-looking and descriptive, not predictive. Therefore, context and additional due diligence remain essential.

Momentum strategies are employed across investor types and trading styles, from retail traders to large institutional funds. Here's how momentum is used in practice and what investors should be aware of when implementing such strategies.

1. Portfolio Construction

Asset managers may harness momentum by allocating capital to outperforming sectors or stocks within the S&P 500, FTSE 100, or other indices. These decisions are typically based on relative strength rankings. A common method is tilting portfolios toward top decile momentum performers while trimming exposure to the bottom decile.

2. Factor Investing

In institutional finance, momentum is classified as an equity factor, alongside others like value, size, or quality. Academic research, including studies by Fama and French, has confirmed that momentum is a persistent anomaly in capital markets. Factor-based strategies seek to diversify exposure and enhance returns.

3. Risk Management and Stop-Losses

Due to the risk of sudden trend reversals, many momentum investors use disciplined exit strategies. Stop-loss levels, often based on trailing averages or volatility, are incorporated to preserve capital. Some also combine momentum with volatility filters to avoid entries in unstable conditions.

4. Sector Rotation

Momentum is pivotal in smart beta strategies and sector rotation models. Fund managers may rotate capital among asset classes or sectors based on recent momentum performance, adapting exposure based on prevailing market conditions. This adaptive approach seeks to capitalise on shifting investor sentiment.

5. Market Timing and Technical Trading

Short-term traders frequently employ momentum indicators for market timing. Oscillators like RSI and stochastic momentum index (SMI) aid entry and exit decisions in fast-moving markets. However, overreliance on indicators without confirming signals can lead to false entries, especially in choppy environments.

Despite its appeal, momentum investing is not foolproof. ‘Momentum crashes’ have historically occurred, where high-flying stocks suddenly reverse direction en masse. This necessitates diversification, dynamic risk control, and the integration of other fundamental and macroeconomic variables into decision-making frameworks.

In conclusion, momentum is an essential yet complex element within financial markets. A proper understanding of its tools, limitations, and applications allows investors to navigate markets with greater insight and precision.