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Momentum trading

What Is Momentum Trading?

Momentum trading is an investment strategy within the broader field of Investment Strategies that aims to capitalize on the continuance of existing price trends. It is based on the premise that assets which have performed well recently (winners) will continue to outperform, and those that have performed poorly (losers) will continue to underperform. Traders using this approach seek to identify strong price movements in a particular direction and then enter trades in the same direction, expecting the trend to persist. Momentum trading often involves quick decisions and active portfolio management, as trends can shift rapidly.

History and Origin

The concept of momentum in financial markets has been observed for centuries, but its academic study and formalization began in earnest in the late 20th century. A pivotal moment for modern momentum trading was the 1993 study by Narasimhan Jegadeesh and Sheridan Titman, published in the Journal of Finance. Their seminal research documented that strategies of buying recent stock winners and selling recent losers generated significantly higher near-term returns than the broader U.S. market. This finding challenged the conventional wisdom surrounding the Efficient Market Hypothesis, which suggests that past price movements should not predict future returns21, 22, 23, 24. The profitability of momentum strategies has continued to be observed in subsequent decades across various asset classes and global markets, leading to extensive academic and practitioner research on the phenomenon19, 20. For further insight into this foundational work, refer to a discussion of Jegadeesh and Titman's seminal research by UCLA Anderson Review.

Key Takeaways

  • Momentum trading is an investment strategy that seeks to profit from the persistence of existing price trends in financial markets.
  • It typically involves buying assets that have shown recent strength and selling those that have shown recent weakness.
  • The strategy relies on the belief that current trends are likely to continue for a period.
  • Momentum strategies often require active monitoring and can be associated with higher volatility.
  • The effectiveness of momentum has been widely studied, with many researchers attributing its persistence to various behavioral biases among investors17, 18.

Formula and Calculation

Momentum is typically calculated as the cumulative return of an asset over a specific look-back period, often ranging from 3 to 12 months, excluding the most recent month to avoid short-term reversals.

A common way to calculate an asset's momentum is using its total return over a defined period. If (P_t) is the price of an asset at time (t) and (P_{t-n}) is the price (n) periods ago, the momentum ((M)) can be expressed as:

M=Pt−Pt−nPt−nM = \frac{P_t - P_{t-n}}{P_{t-n}}

Where:

  • (M) = Momentum
  • (P_t) = Current price of the asset
  • (P_{t-n}) = Price of the asset (n) periods ago

For example, if analyzing 12-month momentum, (n) would represent 12 months, and the calculation would use the price from 12 months prior. This calculation of total return helps identify which assets have been "winners" or "losers" over the chosen period.

Interpreting Momentum Trading

Interpreting momentum in the context of trading involves identifying whether an asset or market index is exhibiting a strong upward or downward trend. A positive momentum value indicates that an asset's price has been increasing over the selected period, suggesting an upward trend. Conversely, a negative momentum value indicates a downward trend.

Traders interpret strong positive momentum as a signal to take a long position (buy) in the asset, anticipating further price appreciation. Strong negative momentum may lead to taking a short selling position (selling borrowed assets) or avoiding the asset, expecting further declines. The strength and consistency of the momentum, rather than just its direction, are crucial for interpretation. For instance, consistently strong positive momentum, characterized by a smooth upward price trajectory, may be viewed more favorably than sporadic or volatile movements. Investors also consider the broader market sentiment to gauge the sustainability of identified trends.

Hypothetical Example

Consider a hypothetical scenario with two technology stocks, TechCo A and InnovateCorp. A momentum trader is analyzing their performance over the past six months to decide which to buy.

  • TechCo A: Started at $100 per share six months ago, now trades at $125.
  • InnovateCorp: Started at $50 per share six months ago, now trades at $45.

Calculating Momentum:

For TechCo A:

MTechCoA=$125−$100$100=0.25 or 25%M_{TechCoA} = \frac{\$125 - \$100}{\$100} = 0.25 \text{ or } 25\%

For InnovateCorp:

MInnovateCorp=$45−$50$50=−0.10 or −10%M_{InnovateCorp} = \frac{\$45 - \$50}{\$50} = -0.10 \text{ or } -10\%

In this example, TechCo A has a positive momentum of 25%, indicating it has been a "winner" over the past six months. InnovateCorp has a negative momentum of -10%, making it a "loser." Based purely on a momentum trading strategy, the trader would consider taking a long position in TechCo A, expecting its upward trend to continue, while likely avoiding or potentially shorting InnovateCorp. This approach is a form of trend following.

Practical Applications

Momentum trading is widely applied across various financial markets, including equities, commodities, and currencies. Its practical applications span different levels of investing and analysis:

  • Individual Stock Selection: Traders identify stocks with strong recent price performance (upward momentum) or weak performance (downward momentum) and make trading decisions accordingly. This often involves screening for stocks that have outperformed their peers or the broader market over a specific period.
  • Sector and Industry Rotation: Investors apply momentum principles to sectors or industries, rotating capital into areas of the market that are showing strong relative performance and out of those lagging.
  • Factor Investing: Momentum is recognized as a persistent factor in asset returns, alongside factors like value, size, and quality. Many quantitative and institutional investors incorporate momentum as a distinct factor in their factor investing models and asset allocation strategies to enhance returns or manage risk13, 14, 15, 16. Firms like AQR Capital Management have developed specific indices and funds to capture the momentum effect across various asset classes11, 12.
  • Algorithmic Trading: Due to its quantitative nature, momentum trading strategies are frequently implemented through algorithms, including high-frequency trading (HFT). These automated systems can identify and execute trades based on momentum signals at speeds unachievable by human traders, though they are subject to regulatory oversight by bodies like FINRA due to potential market impacts8, 9, 10.

Limitations and Criticisms

While momentum trading has demonstrated historical profitability, it is not without limitations and criticisms. One significant concern is the potential for "momentum crashes," where strong upward trends reverse sharply and unexpectedly, leading to substantial losses. Such crashes often occur during periods of high market volatility or during market recoveries following significant downturns. Regulatory bodies, such as the U.S. Securities and Exchange Commission (SEC), actively monitor market volatility and remind investors of the risks associated with rapid price movements7.

Critics also point to the strategy's reliance on past performance, arguing that it may conflict with the concept of market efficiency, which suggests that all available information is already reflected in asset prices. Furthermore, the high turnover rates associated with active momentum strategies can lead to significant transaction costs, which may erode potential profits, especially for individual investors6. Behavioral economists debate the underlying causes of momentum, with explanations ranging from investor underreaction or overreaction to new information to the presence of feedback trading loops4, 5. Some, like Nassim Nicholas Taleb, a prominent author and former options trader, have expressed skepticism about relying on models that do not account for extreme, unpredictable events (Black Swans), which could severely impact momentum strategies1, 2, 3.

Momentum Trading vs. Contrarian Investing

Momentum trading and contrarian investing represent fundamentally opposing philosophies in the financial markets. Momentum trading, as discussed, is predicated on the idea that trends persist, advocating for buying assets that have recently performed well (winners) and selling those that have performed poorly (losers). The belief is that the market's current direction will continue.

In contrast, contrarian investing seeks to profit by going against prevailing market trends or sentiment. Contrarian investors look for assets that are currently out of favor, have underperformed, or are undervalued, believing that their prices will eventually revert to their intrinsic value. They aim to "buy low and sell high" by taking positions in distressed assets, anticipating a turnaround. While momentum traders follow the herd, contrarian investors actively seek opportunities by standing apart from it, often focusing on fundamental analysis rather than price trends.

FAQs

Q: Is momentum trading suitable for beginners?
A: Momentum trading can be challenging for beginners due to its active nature and the need for constant monitoring. It requires a solid understanding of risk management and market dynamics. Beginners might find it more accessible to start with simpler, long-term diversification strategies.

Q: What is the typical timeframe for momentum trading?
A: The timeframe for momentum trading can vary. Academic studies often examine momentum over short to medium horizons, such as 3 to 12 months for formation periods and subsequent holding periods of 3 to 12 months. However, in practice, traders may operate on much shorter or slightly longer timeframes, depending on their strategy and the asset class.

Q: How does momentum trading relate to technical analysis?
A: Momentum trading is closely related to technical analysis because both focus on analyzing past price and volume data to predict future price movements. Many momentum traders use technical indicators, such as moving averages or the Relative Strength Index (RSI), to identify and confirm trends and entry/exit points for trades.