What is Momentum Trading?

Momentum trading is based on the premise that assets demonstrating strong recent performance will likely continue to outperform in the near future, while underperforming assets will continue to lag. In simple terms: "buy high and sell higher" (or "sell low and buy lower" for short positions).

This strategy exploits a well-documented market anomaly—the momentum effect—where past winners tend to continue winning and past losers tend to continue losing over periods of 3 to 12 months.

The Theory Behind Momentum

Several behavioral and structural factors explain why momentum exists:

  • Underreaction to news: Investors often don't immediately incorporate new information into prices
  • Herding behavior: Traders follow trends, creating self-reinforcing price movements
  • Confirmation bias: Investors seek information that confirms their existing positions
  • Slow information diffusion: News takes time to reach all market participants

Types of Momentum Strategies

Time-Series Momentum (Trend Following)

Compares an asset's current price to its own historical prices. If a stock is above its 12-month average, go long; if below, go short or stay flat.

Time-Series Momentum Rules

  • Signal: Compare current price to N-period moving average
  • Long: Price > Moving Average
  • Short/Flat: Price < Moving Average
  • Common periods: 50, 100, or 200 days

Cross-Sectional Momentum

Ranks assets relative to each other. Buy the top performers (top 10-20%) and sell the worst performers (bottom 10-20%) within a universe of stocks.

Cross-Sectional Momentum Rules

  • Universe: S&P 500 or similar liquid stocks
  • Ranking period: Past 12 months (excluding most recent month)
  • Long: Top 10% of performers
  • Short: Bottom 10% of performers
  • Rebalance: Monthly

Key Momentum Indicators

  • Rate of Change (ROC): Measures percentage price change over a period
  • Relative Strength Index (RSI): Momentum oscillator measuring speed and magnitude of price changes
  • MACD: Shows relationship between two moving averages
  • 52-Week High/Low: Price proximity to yearly extremes

Risk Considerations

Momentum strategies have specific risks you must understand:

  • Momentum crashes: Can experience severe drawdowns during market reversals
  • High turnover: Frequent rebalancing increases transaction costs
  • Crowded trades: Popular momentum stocks can become overvalued
  • Timing risk: Entering late in a trend can lead to losses during reversals
Best Practices

Combine momentum with other factors (value, quality) to reduce crash risk. Consider using trailing stops to protect profits during reversals.