2 – M1L6 02 Momentumbased Signals V4

Newton’s first law of motion states that an object at rest stays at rest, and an object in motion stays in motion with the same speed and in the same direction, unless acted upon by an unbalanced force. While Newton’s laws may seem to have little to do with the vagaries of the stock market, a similar behavior is often noted in security prices, that is, rising stock prices seem to continue to rise for some time, while falling stock prices continue to fall. This observed phenomenon is popularly known as momentum. But, stocks are not like physical objects, so what causes this effect? Honestly, no one really knows. There are several factors that seem to contribute to it including human behavior. People don’t want to miss out on an opportunity to make money, and tend to follow the heart. People also tend to under-react to news. New information propagates over time leading to a prolonged effect on stock prices. There is a branch of trading strategies that attempts to capitalize on such trends, and while there is no standard method to quantify momentum signals, a few common techniques include: technical indicators such as moving averages, large price movements with volume, and stocks making new highs. In the next section, we shall look at one example momentum strategy and evaluate its potential using statistical analysis. The general premise of this trading signal is that, out-performing stocks tend to keep their momentum and continue to remain out-performers for some more time in a particular market and vice versa for under-performers. If you believe in momentum being a repeating market phenomenon, it may be a good opportunity to buy out performers and sell under-performers, capitalizing on the continuation of their movement.

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