What Is Momentum Investing?
Momentum investing is a strategy that aims to capitalize on the continuance of an existing market trend. It is a trading strategy in which investors buy securities that are already rising and look to sell them when they look to have peaked
Momentum, in markets, refers to the capacity for a price trend to sustain itself going forward.
Key Takeaways
- Momentum investing is a strategy that aims to capitalize on the continuance of existing trends in the market.
- Market momentum is the ability for a price trend to sustain itself and continue.
- Momentum investing usually involves a strict set of rules based on technical indicators that dictate market entry and exit points for particular securities.
- Few professional investment managers make use of momentum investing, relying instead on fundamental factors and value indicators.
Understanding Momentum Investing
Momentum investing involves going long on stocks, futures, market exchange-traded funds (ETFs), or any financial instrument showing upward-trending prices and short the respective assets with downward-trending prices.
Momentum investing holds that trends can persist for some time and that it’s possible to profit by staying with a trend until its conclusion, no matter how long that may be. For example, momentum investors that entered the U.S. stock market in 2009 generally enjoyed an uptrend until December 2018.
Although he wasn't the first to use the strategy, fund manager and businessman Richard Driehaus is often credited as being the father of momentum investing.
Momentum Investing Methods
Momentum investing usually involves abiding by a strict set of rules based on technical indicators that dictate market entry and exit points for particular securities.
Momentum investors sometimes use two longer-term moving averages (MAs), one a bit shorter than the other, for trading signals. Some use 50-day and 200-day MAs, for example. In this case, the 50-day crossing above the 200-day creates a buy signal, while a 50-day crossing back below the 200-day creates a sell signal. A few momentum investors prefer to use even longer-term MAs for signaling purposes.
Another type of momentum investing strategy involves following price-based signals to go long on sector ETFs with the strongest momentum, while shorting the sector ETFs with the weakest momentum, then rotating in and out of the sectors accordingly.
Other momentum strategies involve cross-asset analysis. For example, some equity traders closely watch the Treasury yield curve and use it as a momentum signal for equity entries and exits. A 10-year Treasury yield above the two-year yield generally is a buy signal, whereas a two-year yield trading above the 10-year yield is a sell signal. Notably, the two-year versus 10-year Treasury yields tend to be a strong predictor of recessions, and also has implications for stock markets.
In addition, some strategies involve both momentum factors and some fundamental factors. One such system is CAN SLIM, made famous by William O’Neill, founder of Investor’s Business Daily. Since it emphasizes quarterly and annual earnings per share (EPS), some may argue it’s not a momentum strategy, per se. However, the system generally seeks stocks with both earnings and sales momentum and tends to point to stocks with price momentum, as well.
If you intend to practice momentum investing, make sure you choose the proper securities and consider their liquidity and trading volume.
Like other momentum systems, CAN SLIM also includes rules for when to enter and exit stocks, based mainly on technical analysis.
The Debate Over Momentum Investing
Few professional investment managers make use of momentum investing, believing that individual stock picking based on an analysis of discounted cash flows (DCFs) and other fundamental factors tend to produce more predictable results, and is a better means of beating index performance over the long term. "As an investment strategy, it’s a thumb in the eye of the efficient market hypothesis (EMH), one of the central tenets of modern finance," to quote a UCLA Anderson Review article, "Momentum Investing: It Works, But Why?"
However, momentum investing has its advocates. A 1993 study published in the Journal of Finance documented how strategies of buying recent stock winners and selling recent losers generated significantly higher near-term returns than the U.S. market overall from 1965 to 1989.
More recently, the American Association of Individual Investors (AAII) found that CAN SLIM can beat the when looking at trailing five-year and 10-year periods, and has beaten it soundly over an even longer time frame.
What Technical Indicators Can Momentum Traders Use?
There are several momentum indicators that technical analysts can use in momentum trading. Among the most popular include the relative strength indicator (RSI), price rate of change (ROC), stochastics, and moving average convergence divergence (MACD).
What Is the Formula For Market Momentum?
Generally, market momentum can be defined from the following equation:
M=V−Vxwhere:V=ThelatestpriceVx=Theclosingpricexnumberofdaysago
What Is the Market Psychology Behind Momentum Trading?
Momentum traders benefit from herd mentality, greed, and fear of missing out. This can lead bull markets to rise higher than fundamentals might predict. Fear of losses and panic can likewise lead selloffs to become crashes.
