Momentum trading refers to focusing on stocks that are volume movers of the day with the traders investing in stocks that are moving in one direction on high volume to reap the desired profits from the upward price trends. To put it in simpler words, momentum trading is largely influenced by the concept that a winning stock is likely to continue outperforming the losing one over the course of a trading day. These trend-based decisions are largely influenced by the effects of certain incidents or news events on the market volatility or general predictions of the stock market. However, there are certain misconceptions regarding momentum trading that are likely to cloud your judgment when you are trying to focus on the hot stocks in the market.
While momentum trading might be a higher turnover strategy when compared to the others such as value investing, the average trading costs for the former are pretty low. Despite the fact that most investors are apprehensive of trading costs eating into their returns, most funds today are available at a nominal transaction fee or redemption charges. As a result, momentum gains can easily survive and even overcome trading costs.
Although most investors are led to believe that it is a new concept, momentum trading actually has a longer history than most other forms of trading. There have been authentic records of real world momentum trading since 1980 with some of them having evidence of existence as long as 200 years ago.
One of the most common myths regarding momentum trading is that since it incorporates higher turnover strategies, it will inevitably equate to higher taxes. On the flip-side, momentum trading can actually be tax advantageous to the investor! This is because the momentum traders hold on to the fast moving stocks and sell the under-performers, thus compromising short-term capital gains for long term capital gains which in comparison are more efficient in lowering the tax burden.
Just like other investment strategies, momentum trading too has seen its dark days and cannot always be the best performing strategy in the market. However, the occasional losses are certainly not indicative of the overall strength and health of the momentum trading strategy.
Studies indicate that momentum trading is an effective strategy that has worked fairly well across different asset classes and markets and is worthwhile of being incorporated in your regular investment strategies.
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