Momentum Trading | Europe and India

For the longest time ever, the Europeans were using goods from India.

Spices, textiles, dyes, perfumes, and wood.

But how did these goods reach Europe? The journey was achingly slow.

The items would get traded from India to neighboring kingdoms and empires in the Middle East. From there, they would slowly make their way to Europe, flowing via many kingdoms, taxed multiple times, traded among tens of traders, consumed by local customers, until eventually some items unsold reached Europe.

Still, there was immense demand. And the Europeans wanted more.

Unluckily for them, they could not have more. In fact, their supply of Indian origin goods went from little to zero.

A crucial territory in between – Turkey – had a change of rulers around the 1400-1500 period. The new rules had different ambitions. They made trade via land almost impossible.

And thus, the Europeans were left wanting more.

Do note that this route was their source of goods not only from India but also from China in a massive way.

And with that grew a new need. Find a sea-based route to India and China.

African Coast

Many European rulers sent their best explorers to look for a way to India and the far east.

It was not a small task because to get to India, they would have to cross Africa first. They would have to start sailing along the western coast of Africa and eventually reach the bottom-most tip of Africa. This journey would still be along the coast.

Then, they would have to turn around and move towards India into the open sea without another coast for thousands of kilometers.

Several groups of explorers and their ships struggled with just the western coast, let alone reaching the southern tip.

The weather was unforgiving, and sudden storms were common. The waves were tall and violent. The seabed was rocky, and hidden reefs damaged ships.

Over the years, some explorers did manage to find their way to the southern tip of Africa.

But then, the challenge of the great Indian Ocean held them back.

Navigating the Indian Ocean proved to be a wall between the European and Indian traders.

Besides being unfamiliar and lacking good maps, the Indian Ocean had a monsoon problem. The monsoons were a strong rain and wind force. And they were seasonal – so at one point in the year, they would blow in one direction, and at another, in another direction.

This was a novelty for many sailors who were surprised by the strong winds and rain, and its lack of predictability.

Vasco

In Goa, there’s a railway station called Vasco-da-Gama Railway Station. The area itself is called Vasco-da-Gama.

Vasco da Gama was the first successful sailor to find a way to reach India.

While many had failed, Vasco had managed to reach India on May 20, 1498, landing in Calicut, Kerala.

Why?

He stopped fighting the monsoon winds. He studied them. And he worked in a manner so as to follow them – not go against them.

When docked at a port in eastern Africa, he enlisted the help of a local captain who understood the region well.

Using the direction the monsoon winds were flowing towards, they were able to reach in only 23 days.

On his return journey, he decided to ignore the winds. The same journey back took him 90 days.

On his multiple journeys to India, he timed his travels to match the wind – while on his way to India and back.

Other sailors picked up on this.

And soon, Indo-European trade was booming via the sea route.

Momentum Investing

Momentum investing is similar to Vasco’s strategy of using the monsoon winds. Instead of trying to find ways to defy the wind or find narrow passages where the wind was not blowing, why not just align with the wind?

In a momentum strategy, investors invest in stocks that are going up. And sell those that are falling.

They don’t necessarily care about valuation or other metrics.

Buy high, sell higher.

That line does not sit well with many investors. But that’s essentially what the momentum investing strategy aims to do.

The idea is that stocks that are doing well will continue to do well in the future. They will have ‘momentum’.

Good companies are good companies. People like buying their shares. Their revenues keep rising. Their share price keeps rising. Investors will keep buying shares of such companies. And therefore, the share price will keep going up. That’s the belief.

Many investors have performed backtests to validate this belief.

Indeed, it looks like momentum has done quite well.

But obviously it can’t be this simple, right?

Yes, it is not that simple.

While the basic idea of momentum investing remains the same, the rules change from one investing style to another.

Which stocks are eligible?

Every stock behaves differently. So naturally, not all stocks would suit all momentum investors’ style.

They try to choose stocks that are not too volatile and are easily bought/sold.

Some investors stick to stocks from a certain sector. Some choose stocks above a certain size (market cap). Some like stocks that are above a certain trading volume.

How do you define “stocks going up”?

How much does a stock need to go up for you to consider it a stock worth buying?

And how much does it need to fall for you to sell it?

Momentum as a strategy is used by investors in multiple avatars.

There are momentum traders, momentum long-term investors, and everything in between.

The challenge with momentum is when the winds turn.

Momentum seems to work well during a bull run. When the markets are rising.

In recent years, there have been periods when the markets have kept rising for many years. In such periods, many kinds of momentum strategies worked well.

It’s usually the transition from a bull to a bear market where the strategy suffers. A sudden change leads to sharp falls in winning stocks. And momentum strategies backfire. It's similar to the rapid changes in wind direction that happen on African coasts. It’s not predictable. And it prevents you from continuing on your path.

Some investors know when to be alert, when to use momentum, and when to stop. They invest based on the way the markets behave.

Like Vasco, they move in the direction the wind is blowing.