Table of Contents
What Is Momentum Investing?
Let me explain momentum investing to you directly: it's a strategy where you aim to profit from the ongoing direction of market trends. As an investor, you buy securities that are already on the rise and plan to sell them once they seem to have reached their high point.
In the markets, momentum means a price trend's ability to keep going forward on its own.
Key Takeaways
You should know that momentum investing focuses on riding the wave of current market trends to make gains. Market momentum is essentially how a price trend maintains itself over time. This approach often follows rigid rules from technical indicators to decide when to enter or exit trades on specific securities. Most professional managers skip momentum investing and stick to fundamentals or value metrics instead.
Understanding Momentum Investing
When you engage in momentum investing, you're going long on stocks, futures, ETFs, or other instruments with prices trending up, and shorting those trending down. The core idea is that these trends can last for a while, allowing you to profit by sticking with them until they wrap up, regardless of the duration. Take the U.S. stock market from 2009: momentum investors who jumped in enjoyed the uptrend right up to December 2018.
Fast Fact
Here's a quick note: while he wasn't the originator, Richard Driehaus, a fund manager and businessman, is often called the father of momentum investing.
Momentum Investing Methods
Momentum investing typically means following a strict set of rules derived from technical indicators to pinpoint entry and exit points for securities. You might use two longer-term moving averages, with one slightly shorter than the other, to generate signals. For instance, some rely on 50-day and 200-day MAs: when the 50-day crosses above the 200-day, that's a buy signal, and the reverse is a sell signal. Others opt for even longer-term MAs for this purpose.
Another method has you going long on sector ETFs showing the strongest momentum and shorting those with the weakest, then rotating between sectors as needed. Some strategies look across assets; equity traders, for example, monitor the Treasury yield curve for signals. A 10-year yield above the two-year often signals a buy, while the two-year above the 10-year signals a sell. This yield spread is a solid recession predictor and affects stock markets too.
Certain strategies mix momentum with fundamentals, like the CAN SLIM system from William O’Neill of Investor’s Business Daily. It stresses quarterly and annual EPS, so some say it's not pure momentum, but it targets stocks with earnings, sales, and price momentum. Like other systems, CAN SLIM uses technical analysis rules for entering and exiting positions.
Important
If you're planning to try momentum investing, select the right securities and pay attention to their liquidity and trading volume.
The Debate Over Momentum Investing
Professional investment managers seldom use momentum investing; they believe analyzing discounted cash flows and other fundamentals leads to more reliable results and better long-term outperformance against indexes. As a strategy, it challenges the efficient market hypothesis, a key principle in modern finance, as noted in a UCLA Anderson Review article titled 'Momentum Investing: It Works, But Why?'
Still, it has supporters. A 1993 Journal of Finance study showed that buying recent winners and selling losers produced much higher short-term returns than the U.S. market from 1965 to 1989. More recently, the American Association of Individual Investors found CAN SLIM outperforming the S&P 500 over five- and 10-year periods, and even more so over longer spans.
What Technical Indicators Can Momentum Traders Use?
Momentum traders have several indicators at their disposal, including the relative strength index (RSI), price rate of change (ROC), stochastics, and moving average convergence divergence (MACD).
What Is the Formula For Market Momentum?
You can calculate market momentum with this equation: M = V - Vx, where V is the latest price and Vx is the closing price x days ago.
What Is the Market Psychology Behind Momentum Trading?
Momentum trading taps into herd mentality, greed, and fear of missing out, which can push bull markets higher than fundamentals suggest. Similarly, fear of losses and panic can turn selloffs into full crashes.
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