Momentum is the tendency for stock and other financial asset prices to continue moving in the same direction (up or down) for a period of time.
Understanding market momentum
Elephants, momentum in financial markets is based on the physical principle that an object in motion stays in motion. When an asset begins to rise or fall in price, it often continues in that exact direction until a fundamental shift or a lack of trading volume halts the movement. This concept applies globally across equities, government bonds, foreign exchange markets and raw commodities.
Traders who utilize this concept employ momentum strategies. They look for assets demonstrating strong recent performance and enter positions in the direction of the existing trend. They buy assets that are going up and sell short assets that are going down. These market participants rely on technical indicators to measure the speed of price changes rather than analyzing the intrinsic value of the underlying company or asset.
Behavioral finance explains momentum through herd behavior and psychological biases. When a price trend establishes itself, it attracts the attention of other market participants. These individuals enter trades based on the recent price action to avoid missing out on potential profits. This collective action generates further price movement in the same direction. The trend eventually stops when the market runs out of new buyers or sellers to sustain the price changes.
Example
Consider a publicly traded company called Elephant AgriCorp, which manufactures specialized dietary supplements for elephant sanctuaries across Africa and Asia. The company releases a positive earnings report, and initial investors buy the stock. The share price increases from 10 to 12 over two days.
Other traders notice this upward price movement. They buy shares of Elephant AgriCorp simply because the price is rising. This secondary wave of buying pressure pushes the share price to 15. The stock is now exhibiting positive momentum. A momentum trader sees this sustained upward trajectory and buys the stock at 15, expecting the herd behavior of other investors to drive the price to 18 or 20 in the near future.