Momentum Investing

Momentum Investing

What is momentum investing?

Momentum investing is a strategy that seeks to profit from the continuation of existing market trends. Investors buy securities whose prices are rising (go long) and may short securities whose prices are falling, aiming to ride trends until signs of reversal.

Key takeaways

• Momentum relies on the tendency of price trends to persist for a period of time.
• It is largely rule‑based and driven by technical signals for entry and exit.
• Momentum can be applied to stocks, ETFs, futures and across sectors or asset classes.
• Practical risks include trend reversals, liquidity constraints, transaction costs and tax consequences.

How it works

Momentum strategies identify recent winners and losers using price-based measures or technical indicators, then take positions that align with those trends. A simple real-world example: investors who bought U.S. equities after the 2009 market low benefited from a long uptrend that lasted for years. The strategy is tactical—holding positions while momentum persists and exiting when signals indicate the trend has ended.

Common methods and signals

• Moving average crossovers: e.g., a shorter moving average (50‑day) crossing above a longer one (200‑day) generates a buy signal; the reverse generates a sell signal.
• Sector rotation: go long sector ETFs with the strongest momentum and short those with the weakest, rotating as relative strength changes.
• Cross‑asset signals: use indicators such as the Treasury yield curve (e.g., 10‑yr vs. 2‑yr yields) as timing signals for equities—an inverted curve often presages trouble.
• Hybrid systems: combine momentum with fundamentals (examples include CAN SLIM‑style approaches that target earnings and sales momentum alongside price momentum).
• Technical indicators commonly used: Relative Strength Index (RSI), Rate of Change (ROC), Stochastics, and MACD.

A simple momentum formula

A basic way to measure momentum over x days:
M = V − Vx
where:
* V = latest price
* Vx = closing price x days ago

A positive M indicates upward momentum; a negative M indicates downward momentum.

Market psychology

Momentum often feeds on herd behavior, greed and fear of missing out (FOMO). These forces can extend rallies beyond fundamental justification and accelerate selloffs during panic, amplifying moves in either direction.

Criticisms and risks

• Academic debate: momentum appears to generate excess short‑term returns in many studies, but it challenges the efficient market hypothesis and remains contested in terms of why it works.
• Practitioner adoption: many professional managers favor fundamental analysis (e.g., discounted cash flow) and value approaches, citing predictability and long‑term focus.
• Practical risks: sharp reversals (momentum crashes), high turnover, trading costs, slippage, and poor performance in choppy markets. Liquidity and volume are important—thinly traded securities can produce unreliable signals and large execution costs.

Practical tips

• Define clear entry and exit rules and strictly follow them.
• Backtest strategies on out‑of‑sample data and across market regimes.
• Limit exposure to illiquid securities; prefer instruments with adequate volume.
• Manage risk with position sizing and stop rules to protect against sudden reversals.
• Consider combining momentum signals with fundamental filters to reduce false signals.

Selected research

• Jegadeesh, N., & Titman, S. (1993). Returns to buying winners and selling losers. Journal of Finance.
• Studies and practitioner analyses of CAN SLIM and other hybrid systems assess how blending earnings momentum with price momentum affects returns.