Summary The 1990s spawned the internet and with it the possibility of momentum investing for individual investors. Momentum investing is a strategy that is based on price momentum with investors taking short-term positions to quickly gather a profit. Using one or more technical indicators to confirm price trends, a momentum trader buys as stocks continue to go up and sell, or close their position as soon as a stock shows signs of going down. This type of trading runs contrary to a more classical, long-term investment strategy that buys stocks when they are on sale and sells them for a higher price. Momentum trading is also different from long-term investing in that it focuses on a very short time period, sometimes even measured in seconds or minutes.
A successful momentum strategy takes into account a defined profit target and then tracks market momentum and uses trading tools such as a stop loss to ensure that they exit out of trades at appropriate times. Momentum investing can be highly profitable, but it comes with above average risk. However, some would argue that momentum investing is no riskier than other types of investing because investors are not trying to time the market in a fundamental sense, but only opening and/or closing positions based on specific price trends and sometimes limiting their trades to a specified time period.
For many investors, investing is about buying low and selling high. Particularly in times of market volatility, there is logic to buying stocks that are oversold and riding the wave as those same stocks recover and move higher. In fact, buy low and sell high is the axiom of value investors and growth investors alike.
However, there is another category of investing that is growing in popularity after a 20-year period where it was largely ignored by investors. It’s called momentum investing and it requires self-discipline and a commitment to technical analysis.
In this article, we’ll review what momentum investing is and how it’s different from long-term investing. We’ll also review both the benefits and the drawbacks to momentum investing and review the anatomy of a successful momentum trade.
What is momentum investing?
Momentum investing is a trading strategy that requires investors to identify chart patterns for indications of stocks that are riding a trend. The concept for momentum traders is to “trade with the trend”. This means that you are buying stocks that are rising and you are selling stocks that are declining. It is the exact opposite of what many investors are taught which is to trade against the trend (i.e. buy stocks that are oversold and sell stocks that are overbought).
How is momentum investing different from long-term investing?
Momentum investing is different from long-term investing in several key ways. One of the key attributes involved with momentum training is speed. Momentum investors are focused on short-term price movement in securities, usually stocks. Momentum traders are frequently day traders because it is not uncommon for positions to be held for only seconds or minutes. Here are four ways that momentum investing is different from long-term investing:
- Momentum investing requires short-term price movement– Long-term investors want stocks to move upward, but by definition, a long-term investor does not require short-term price movement to own a stock. These investors are committed to holding a position for months, maybe even years. By contrast, a momentum investor is looking to take immediate action on short-term price movement. In order to profit from these trades, momentum traders look for stocks that have a high volume because the volume is what creates momentum. Momentum investors may look at longer-term charts (weeks, months, years) to identify patterns and trends, but in general, they are only looking to trade securities that have high volume.
- Momentum investing focuses on short time frames and holding periods– Momentum investors prioritize short time frames to gauge their trading opportunities. This is because a momentum investor needs the discipline to establish precise entry and exit points. They are only looking to hold a position for very short periods of time – sometimes only seconds or minutes.
- Momentum investing favors technical analysis over fundamental analysis – As you would expect, momentum investing do not simply “trade on the news”, but they use the news to identify stocks that are likely to generate the volume they need. Actual stock price movement, not just speculation fuels their trading. One of the key tools used by momentum traders is a stochastic oscillator, which compares the closing price of a security to a range of prices over a given period of time. When a stock closes near its high, the market is probably close to an uptrend. When a stock closes near a low, the market is probably trending down. A more refined tool is the Stochastic Momentum Index (SMI) that allows traders to use a wide range of values and is more sensitive to closing prices.
- Momentum investing relies on high-frequency trading programs and algorithms – Investors don’t need to be math whizzes to be momentum traders. They do, however, require access to high-speed programs that can execute trades in milliseconds. These programs are typically programmed to give investors access to news and stock quotes very rapidly so as to create the price movement that these investors require.
What are the benefits of momentum investing?
- High-profit potential in a short period of time – Because momentum investors are not concerned about long-term metrics like annualized return, they are ready to capitalize on short-term price movement. When a stock makes a short-term move that causes it to double in value (from $20 to $40 for example), momentum investors can sell the stock at a profit in weeks or months. When this process is repeated over the course of time, they increase their profit potential.
- It leverages market volatility – For investors with a low-risk tolerance, volatility is something to be avoided. Momentum investors, however, embrace volatility and profit by identifying trends and patterns to inform their trading activity in a way that maximizes their return on investment (ROI).
- It capitalizes on emotional responses of other investors – Momentum investors chase performance. But unlike many traders who fall prey to their emotions, momentum investors are very systematic and use technical indicators and tremendous discipline to establish precise buying and selling points. In this way, they can take advantage of stock price movement that is created by emotional investors.
What is the downside to momentum investing?
Momentum investing is not for every investor. It requires a particular risk tolerance and the self- discipline and commitment to execute trades quickly and without second-guessing. Here are some of the more common drawbacks.
- A higher risk of failure – Momentum investing requires precise timing. But even the most experienced momentum investors can fall victim to a poorly timed trade and when they do, they can lose a lot of money. This can be particularly risky if they’re using momentum trading with options or futures contracts. However, the possibility of a higher return makes this a risk that these investors are willing to take.
- They may pay more in fees – Momentum investing requires quick turnover and frequent trading. This also means that momentum investors will pay more in trading fees. Low-cost brokers are making this less of a problem for experienced investors, but it is a cost that momentum traders should account for.
- It takes a lot of time – Momentum investing is a job, not a hobby. To be successful, a momentum investor needs to be constantly plugged into market details and be prepared to take action on a daily, if not hourly basis. This is because they are looking for the short-term price moves that can be caused by a positive or negative news item that can impact a stock.
- It is sensitive to investor caution – Momentum traders do best in a bull market because there are more speculative buyers helping to drive up the volume which can lead to short-term price movement that creates momentum. In bear markets, investors become more cautious which leads to less trading volume.
What do momentum investors look for?
Although momentum investing may feel like the wild west to outsiders, momentum investors know how important it is to follow rules that help manage risks that can reduce profits. The five general rules fall into five categories: security selection, risk control, a precise entry point, managing the trade, and a precise exit point.
Selecting the proper security to trade– In most cases, momentum investors will do better with individual securities that have high liquidity. This is typically defined as a security that is trading more than 5 million shares per day. Many times in life, we are encouraged to stay away from the “flavor of the week”, a momentum investor benefits from finding a story stock that is showing significant price movement and, in many cases, high volume due to some news. In many cases, these may be stocks that do not usually show high liquidity. Funds tend to have smaller percentage movements and if a fund is leveraged or inverse it may be constructed in a way that will cause it not to accurately track with its underlying index or futures contract.
Controlling risk– In order to manage the risk that is inherent in momentum trading, traders need to take great care to avoid the pitfalls of momentum trading including:
- Opening a position too early (i.e. before it is a confirmed momentum trade).
- Closing a position too late (i.e. after the security has already reached a saturation point) and/or not closing a bad position quickly. This could create a situation where a trader is holding onto a momentum trade that is going the wrong way.
- Not paying attention to the news that can surprise the market and cause a trend to quickly reverse.
- Holding a position open overnight can cause momentum investors to give back any and all profit they have made. This is due to news that comes in overnight that will affect the prices and patterns these investors will see in the morning.
Precise entry positions – long-term investors tend to be reactive. They may learn about a significant event, but will typically wait to jump in until they see other investors “confirm” their feeling. Momentum traders look to jump in very quickly when they hear the news that can affect short-term price movement. Jumping in early provides the greatest profit opportunity for the least risk. By the time most growth or value investors are jumping on a trend, many momentum traders are ready to, or have already exited their positions.
Managing the trade – A stock that is trading with high volume and volatility tends to have a wide bid/ask spread. For momentum traders, this means that the stock price will have to show greater price movement in order for a trade to be profitable. In some cases, a wide spread can trigger a stop loss point even though the technical indicators surrounding a stock might signal that an investor would want to stay in the trade. Momentum investors will want to set a “risk-reward” ratio to help manage their potential risk.
Precise exit positions– Momentum traders should look to exit (close) a position when technical indicators show the price is moving into an overextended range. Traders use a variety of technical indicators such as trend lines, crossovers, and Bollinger bands and look to see when technical barriers are breached.
The final word on momentum investing
To some investors, momentum investing may seem more like gambling than a precise investment strategy, but the truth is that momentum investors use highly sophisticated strategies and rules to make profitable trades.
Momentum investing is sometimes described as riding the wave. Instead of buying stocks “at a discount” and selling them when they increase, momentum investors look to find highly liquid stocks that are moving up in price, then using a series of technical indicators to capitalize on this upward trend until the indicators show that there is a trend reversal is imminent.
The biggest difference between momentum investors and long-term investors are that momentum investors are capitalizing on short-term price movement and holding positions for short periods.
Momentum investing is not a practical choice for every investor, particularly when you consider that institutional investors are also trading on momentum and they will usually get out of trades faster than individual investors can. Still, there is an impressive profit to be made for investors who have the discipline and the time to open and close trades at precise points. In many cases, it is better to exit a trade at the first sign of a trend reversing.