Introduction to Momentum Trading

On paper, momentum investing seems less like an investing strategy and more like a knee-jerk reaction to market information. The idea of selling losers and buying winners is seductive, but it flies in the face of the tried-and-true Wall Street adage, “buy low, sell high.”

In this article, we’ll look at momentum investing and its benefits and pitfalls. 

The Father of Momentum Investing

Though not the first momentum investor, Richard Driehaus took the practice and made it into the strategy he used to run his funds. His philosophy was that more money could be made by “buying high and selling higher” than by buying underpriced stocks and waiting for the market to re-evaluate them.

Driehaus, born in 1942, began his career as a research analyst at A.G. Becker in 1968. He quickly gained a reputation for his unconventional approach to investing, which flew in the face of traditional value investing principles popularized by Benjamin Graham and Warren Buffett. Instead of seeking out undervalued stocks, Driehaus focused on companies showing strong growth and a rising price.

In 1982, Driehaus founded his own investment firm, Driehaus Capital Management. It was here that he fully developed and implemented his momentum-based strategy. His approach was simple yet counterintuitive to most investors: buy high and sell higher. Driehaus believed that investors could make significant profits by identifying stocks with accelerating earnings growth, increasing volume, and rising prices.

Principles of Momentum Investing

Momentum investing seeks to take advantage of market volatility by taking short-term positions in stocks going up and selling them as soon as they show signs of going down. The investor then moves the capital to new positions. In this case, the market volatility is like waves in the ocean, and a momentum investor is sailing up the crest of one, only to jump to the next wave before the first wave crashes down again.

A momentum investor looks to take advantage of investor herding by leading the pack in and being the first to take the money and run. Below is a table comparing momentum investing with other common approaches:

Elements of Momentum Investing

Trading momentum markets requires sophisticated risk management rules to address volatility, overcrowding, and hidden traps that reduce profits. Market players routinely ignore these rules, blinded by an overwhelming fear they’ll miss the rally or sell-off while everyone else books windfall profits. The rules can be broken down into five elements:

1. Choose liquid securities.
2. Manage risks when opening and closing the trades.
3. Try to enter early.
4. Choose your holding period wisely.
5. Time your exit carefully.

1. Selecting the Right Security for Momentum Trading

Choose liquid securities when engaging in momentum strategies. Stay away from leveraged or inverse ETFs because their price swings don’t accurately track underlying indices or futures markets due to complex fund construction. Regular funds make excellent trading vehicles but tend to grind through smaller percentage gains and losses compared with individual securities.

Seek out securities that trade more than 5 million shares per day whenever possible. Many popular stocks meet these criteria. Some low float issues can turn into highly liquid instruments when news happens, and volatility spikes as intense emotional reactions draw in market players from diverse sources.

Watch for the “flavor of the day” when new products, divisions, or concepts capture the public’s imagination, forcing analysts to throw away calculations and recompute profit estimates. Biotechs and small to midsize technology companies create a generous supply of these story stocks.

2. Tight Risk Control

The risk side of the equation must be addressed in detail, or the momentum strategy will fail. The pitfalls of momentum trading include the following:

• Jumping into a position too soon—before a momentum move is confirmed.
• Closing the position too late, after saturation has been reached.
• Failing to keep an eye on the market, missing changing trends, reversals, or news that takes the market by surprise.
• Keeping a position open overnight. Stocks are particularly susceptible to external factors occurring after the close of that day’s trading—these factors could cause radically different prices and patterns the next day.
• Failing to act quickly to close a bad position, riding the momentum train the wrong way down the tracks.

3. Perfecting When To Buy a Stock

The best momentum trades come when news of a shock hits, triggering rapid movement from one price level to another. In turn, this sets off buying or selling signals for observant players who jump in and are rewarded with instant profits. Another batch of momentum capital enters as the trade evolves, generating counter swings that shake out weak hands. The hot money finally builds to an extreme, triggering volatile whipsaws and major reversals.

Early positions offer the greatest reward with the least risk, while aging trends should be avoided at all costs. The opposite happens in real-world scenarios because most traders don’t see the opportunity until late in the cycle and then fail to act until everyone else jumps in.

Among the many reasons for the GameStop (GME) meme stock phenomena was the continuous attempts of momentum traders to outpace other traders, a cycle that repeated several times in early 2021:

4. How To Manage Your Position

Position management takes time to master because securities that are best for momentum trades often carry wide bid/ask spreads. Wide spreads mean you need more significant price changes to make a profit, and the large intraday swings can trigger stop-losses, even if the overall trend is still strong. Choose your holding period wisely because the risk increases the longer you stay in your position. 

5. Exiting With Profits

Exit when the price is moving rapidly into an overextended technical state. This overextended state is often identified by a series of vertical bars on the 60-minute chart. Alternately, the price could pierce the third or fourth standard deviation of a top or bottom 20-day Bollinger Band.

Tighten up stops or consider a blind exit when technical barriers are hit like a major trendline or previous high/low. Exit or take partial profits when crossovers signal potential trend changes.

Benefits of Momentum Investing

Momentum investing can turn into large profits for the trader who has the right personality, can handle the risks involved, and can dedicate themselves to sticking to the strategy.

Potential for High Profits Over a Short Period

There are rewards to momentum investing. For example, say you buy a stock that grows from $50 to $75 based on an overly positive analyst report. You then sell at a profit of 50% before the stock price corrects itself. You’ve made a 50% return over the course of a few weeks or months (not an annualized return). Over time, the profit potential increase using momentum investing can be staggeringly large.

Leveraging the Market’s Volatility to Your Advantage

The key to momentum investing is being able to capitalize on volatile market trends. Momentum investors look for stocks to invest in that are on their way up and then sell them before the prices start to go back down. For such investors, being ahead of the pack is a way to maximize return on investment.

Leveraging the Emotions and Rash Decisions of Other Investors

Momentum investors systematically chase profits, hoping to beat the crowd and get out before the reversal. Rather than be controlled by emotional responses to stock prices like many investors are, momentum investors seek to take advantage of the changes in stock prices caused by emotional investors. That requires discipline and having a specific buying point and selling point.

Drawbacks of Momentum Investing

Momentum investing also has several downsides. The same risk-return trade-off that exists with other investing strategies also plays a hand in momentum investing.

Like a boat trying to sail on the crests of waves, a momentum investor is always at risk of timing a buy incorrectly and ending up sunk. Most momentum investors accept this risk as the price for the possibility of higher returns.

High Turnover

High stock turnover can be expensive in terms of fees. Even though low-cost brokers are slowly putting an end to the problem of high fees, this is still a major concern for most rookie momentum traders. 

Time Intensive

Momentum investors have to monitor market details daily, if not hourly. Because they are dealing with stocks that will crest and go down again, they need to jump in early and get out fast. This means watching all the updates to see if there is any negative news that will spook investors. 

Market Sensitivity

Momentum investing works best in a bull market because investors tend to herd a lot more. In a bear market, the margin for profit on momentum investing shrinks in accordance with increased investor caution.

Will It Work for You?

Momentum investing can work, but it’s not practical for all investors. As an individual investor,  momentum trading will most likely lead to overall portfolio losses. When you purchase a rising stock or sell a falling one, you’re likely reacting to older news than the professionals at the head of the momentum investing funds. It often requires frequent trading, sophisticated analysis, and the ability to closely monitor market trends—tasks that can be time-consuming and potentially costly for the average investor.

They will get out and leave you and other unlucky folks holding the bag. If you do manage to time it right, you’ll still have to be more conscious of the fees from turnover and how much they will eat up your returns. 

ETFs and Alternatives for Momentum Investing

Fortunately, several alternatives allow retail investors the ability to gain exposure to momentum strategies without the need for intensive personal management.

Momentum ETFs: The Passive Approach

ETFs that focus on momentum strategies use rules-based approaches to select stocks exhibiting strong price momentum, essentially automating the momentum investing process. Some prominent examples include the following, as well as the oldest and largest ETF tracking the S&P 500 index for comparison with simply passively investing in the market’s largest fund:

These ETFs typically rebalance their holdings periodically (often quarterly) to maintain exposure to stocks showing the strongest momentum characteristics. They offer investors a way to benefit from momentum strategies with the convenience and lower costs associated with passive investing. Below are their average total returns (including dividends) for one, five, and 10 years, along with those of the SPY ETF.

Robo-Advisors with Momentum Tilts

Some robo-advisor platforms now offer portfolio options that incorporate momentum strategies. These automated investment services use algorithms to create and manage portfolios, with some allowing users to tilt their allocations using momentum strategies.

DIY Momentum Screening Tools

For investors who want a more hands-on approach without full-time commitment, many financial and brokerage platforms offer momentum screening tools. These allow you to filter stocks based on momentum indicators, providing a starting point for further research and potential investment.

Drawbacks To Consider

While these alternatives make momentum investing more accessible, they come with their own set of considerations:

• Performance: Momentum strategies can be volatile and may underperform in certain market conditions.
• Costs: ETFs and mutual funds charge fees that can impact overall returns.
• Tax implications: High turnover in momentum strategies can lead to more frequent capital gains distributions.
• Diversification: Though the ETFs above hold stocks broadly across the market, some momentum-focused products may be concentrated in certain sectors or styles, potentially increasing risk.

Momentum Investing Example

To illustrate how momentum investing works, let’s consider a hypothetical scenario involving Stock A and Stock B.

Suppose you invest for six months, and you have $10,000 to invest in each stock. Stock A has shown remarkable performance over the last six months. Its price rises from $50 to $60 in the first month. The following month, it climbs to $75; by the end of the third month, it reaches $85. The upward trend continues, with the price increasing to $90 in the fourth month, $95 in the fifth month, and finally hitting $100 in the sixth month. As a result, the investment in Stock A grows from $10,000 to $20,000, reflecting a remarkable 100% increase.

By contrast, Stock B experiences a downward trajectory. Starting at $50 in the first month, its price declines to $45. The second month sees it drop further to $40, followed by a decrease to $35 in the third month. By the end of the fourth month, the price falls to $30, then to $25 in the fifth month, and finally down to $20 in the sixth month. So, the investment in Stock B decreases from $10,000 to $4,000, resulting in a 60% loss.

In this situation, a momentum investor would focus on Stock A due to its strong upward price trend. After observing its consistent performance over the past months, the investor decides to buy Stock A, anticipating that the upward momentum will continue. Conversely, the investor may short Stock B, expecting its downward trend to continue. As a result, the investment in Stock A yields profits as the price continues to rise, while shorting Stock B can also lead to gains if executed correctly, given its declining price.

The Bottom Line

Momentum trading is not for everyone, but it can yield good returns. It takes discipline to trade this way because the trade must be closed at the first sign of weakness, and the funds must be immediately placed into a different asset showing strength.

The tax implications and the potential for commissions and other fees mean that buying high and selling higher does not come without its fair share of challenges.