Momentum Trading

Momentum trading is based on a simple observation: assets that have performed strongly recently tend to keep performing strongly for a while, and weak assets tend to stay weak. Momentum traders buy strength and sell weakness instead of hunting for bargains. The effect has been documented across stocks, bonds, currencies and commodities and is one of the most studied patterns in finance. It shows up at very different timescales, from intraday surges to multi month trends.

The research#

In 1993, Narasimhan Jegadeesh and Sheridan Titman showed that US stocks that had performed best over the previous 3 to 12 months tended to outperform those that had performed worst over the following months. This "cross sectional momentum" has since been found in many countries and asset classes. A related effect, "time series momentum", looks at each market's own past return. See Trend Following and Momentum Factor.

Types of momentum trading#

Measuring momentum#

• Past return: the most common measure, for example the 12 month return excluding the most recent month. Skipping the last month avoids the short term reversal effect. See Short and Long-Term Reversal.
• Rate of change: percentage change over a lookback. See Rate of Change and Momentum.
• Relative strength: performance compared with an index or sector.
• New highs: assets at or near 52 week highs.
• Volume: strong moves on high Relative Volume suggest real participation.

Intraday momentum#

Short term momentum traders look for stocks "in play": big gaps, earnings surprises or news with unusually high volume. They enter on pullbacks or breakouts of intraday levels, often with tight stops, and aim to ride the move for minutes or hours. Liquidity, spread and halts are major risks with small, fast moving stocks. See Trading Halts and Circuit Breakers and News Trading.

Why momentum might work#

Explanations include:

• Underreaction: investors adjust slowly to new information. See Anchoring.
• Herding: buying attracts more buying as others notice.
• Institutional flows: large funds build positions over weeks.
• Risk: momentum may be compensation for crash risk.

Momentum crashes#

Momentum has occasional severe losses, usually when beaten down assets rebound sharply after a market bottom. In 2009, as markets rebounded, the past losers rallied far more than past winners and long short momentum portfolios suffered large losses within a few months. Kent Daniel and Tobias Moskowitz documented these "momentum crashes". Controlling volatility and avoiding concentrated short positions in heavily sold assets can reduce the damage.

Momentum vs mean reversion#

Momentum and Mean Reversion seem contradictory, but they operate at different horizons. Research generally finds short term reversal (up to a month), momentum over 3 to 12 months and long term reversal over several years. Knowing which horizon you trade is essential.

Common mistakes#

• Buying too late in an extended move with a wide stop.
• Ignoring turnover costs in frequently rebalanced portfolios.
• Concentrating in one sector that happens to lead.
• Not planning for sudden reversals.

Momentum can be measured directly with the Rate of Change and Momentum indicator, a useful filter for momentum entries.

Frequently asked questions#

What is momentum trading?#

A strategy that buys assets with strong recent performance and sells or avoids those with weak performance, expecting the trends to persist.

Does momentum investing work?#

Momentum has been documented across many markets and decades, but it has periods of poor performance and occasional sharp crashes.

What is the best lookback period for momentum?#

Studies often use 3 to 12 months, commonly skipping the most recent month, but results vary by market and should be tested.

Next, learn the opposite effect in Mean Reversion.

Sources#

• Jegadeesh, N. and Titman, S., Returns to Buying Winners and Selling Losers, Journal of Finance, 1993. Summary: Wikipedia, Momentum (finance)