Question

Suppose an investor needs to buy or sell a stock instantaneously and he wants to take advantage of the momentum and capitalize on expected changes in the price of that particular stock. What sort of order should he place under such a scenario? Explain your answer. Answer Should not be less than 500 words.

Answer 1

The concept reffered in the question is  Momentum Trading :

Momentum trading is the practice of buying and selling assets according to the recent strength of price trends. It is based on the idea that if there is enough force behind a price move, it will continue to move in the same direction.

When an asset reaches a higher price, it usually attracts more attention from traders and investors, which pushes the market price even higher. This continues until a large number of sellers enter the market – for example, when an unforeseen event causes them to rethink the asset’s price. Once enough sellers are in the market, the momentum changes direction and will force an asset’s price lower.

Momentum traders will seek to identify how strong the trend is in a given direction, then open a position to take advantage of the expected price change and close the position when the trend starts to lose its strength. A momentum trader doesn’t necessarily attempt to find the top and bottom of a trend, but instead focuses on the main body of the price move. They aim to exploit market sentiment and herding – the tendency for traders to follow the majority.

Momentum in finance is based on the following key factors:

1. Volume
2. Volatility
3. Time frame

Volume

Volume is the amount of a particular asset that is traded within a given time frame. Volume is not the number of transactions, but the number of assets traded – so, if five buyers purchase one asset each, it looks the same as if one buyer purchases five of the asset.

Volume is vital to momentum traders, as they need to be able to enter and exit positions quickly, which relies on there being a steady stream of buyers and sellers in the markets. If a market has a high number of buyers and sellers, it is known as a liquid market as it is easier to exchange an asset for cash. Whereas if a market has a low number of buyers and sellers, it is regarded as illiquid.

Volatility

Volatility is a momentum traders’ bread and butter. Volatility is the degree of change in an asset’s price – if a market is highly volatile, it means that there are big price swings, while a market with low volatility is comparatively stable.

Momentum traders will seek out volatile markets, in order to take advantage of short-term rises and falls in an asset’s value. As momentum trading attempts to capitalise on volatility, it is important to have a suitable risk management strategy in place to protect your trades from adverse market movements. This should include stops and limits.

Time frame

Momentum trading strategies are usually focused on short-term market movements, but the duration of a trade can depend on how long the trend maintains its strength. This could make is suitable for traders who employ longer-term styles such as position trading, as well as those who prefer short-term styles, such as day trading and scalping.

Sort sof order to be placed are:

Take the example of Amazon and Netflix, where the 5 yr and 3 yr returns have been above 125%. And in fact, Netflix beats the game, offering more than 375% returns over a 5-year period.

While the returns from momentum investing can be big, it involves investors to monitor the price of the securities on a regular basis. While this might sound easy, it is not that simple. Momentum stock investing can at times be misleading and cause frustration for the investor.

Imagine picking a stock that has rallied 15% in the past six months. This would lead the investor to pick some stake in such stocks, only to see the momentum fade in a few months time. This can lead to locked up capital and can be quite frustrating at times.

In order to have the best momentum picks, investors need to make use of the right set of tools. Unlike traditional investing, momentum investing requires a close mix of both fundamentals and the technical analysis of the securities.

Momentum investing can be very rewarding if the investor is able to master the tools of the trade. One of the biggest benefits of momentum investing is that you can play the markets both when the stocks are rising and when the stocks are falling.