Price momentum

What Is Price Momentum?

Price momentum is a concept within technical analysis that suggests that assets which have performed well in the recent past tend to continue to perform well, and assets that have performed poorly tend to continue to perform poorly. This phenomenon, often observed in stock prices and other financial markets, is rooted in the belief that existing trends in asset prices persist rather than reverse abruptly. It belongs to the broader quantitative finance category, relying on measurable data to identify potential trading or investing opportunities. Investors and traders utilize price momentum to identify securities that are exhibiting strong upward or downward trends, aiming to capitalize on the continuation of these movements.

History and Origin

The concept of price momentum, while seeming intuitive, gained significant academic recognition relatively recently. Early observations of trending behavior in financial markets can be traced back to figures like Charles Dow in the late 19th and early 20th centuries, who noted that stock prices tended to move in trends. However, systematic academic research on the phenomenon often credits Narasimhan Jegadeesh and Sheridan Titman's seminal 1993 paper, "Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency." This paper provided robust empirical evidence that strategies buying past winning stocks and selling past losing stocks generated significant positive returns over three- to twelve-month periods, challenging the then-prevailing notion of strong-form market efficiency.²⁵ Their findings highlighted price momentum as a persistent market anomaly, sparking further research and its adoption into various investment strategies.¹⁷, ¹⁸, ¹⁹, ²⁰, ²¹, ²², ²³, ²⁴

Key Takeaways

• Price momentum is the tendency for assets that have performed well or poorly in the recent past to continue that performance.
• It is a core concept in technical analysis and is used to identify and capitalize on existing price trends.
• The strategy involves buying securities with strong positive momentum and selling those with strong negative momentum.
• While historically effective, price momentum strategies are susceptible to sudden reversals, known as "momentum crashes," and require active risk management.
• Its persistence challenges the concept of fully efficient markets, suggesting that behavioral biases or slow information diffusion may play a role.

Formula and Calculation

Price momentum is typically calculated by looking at the percentage change in an asset's price over a specific look-back period. Common look-back periods include 3 months, 6 months, or 12 months, often excluding the most recent month to avoid short-term reversals or liquidity effects.

The basic formula for calculating price momentum (or simple return) is:

Where:

• ( P_t ) = Current price of the asset
• ( P_{t-n} ) = Price of the asset ( n ) periods ago (e.g., 3 months, 6 months, 12 months)

For practical application in portfolio construction, a rank-based approach is often used, where assets are sorted by their momentum values, and the top (winners) and bottom (losers) are selected.

Interpreting Price Momentum

Interpreting price momentum involves identifying whether an asset's price trend is likely to continue in its current direction. A positive price momentum indicates that an asset's price has been increasing over the selected time horizon, suggesting an upward trend. Conversely, negative price momentum implies a downward trend.

Traders and investors often look for a high and sustained positive momentum as a signal to buy, expecting the upward trend to persist. Similarly, strong negative momentum might signal a short-selling opportunity or a reason to avoid or sell an asset. The strength of the momentum, often indicated by the magnitude of the price change and accompanied by high volume, is crucial. A rapid acceleration in price can suggest strong underlying demand or supply, potentially indicating continued movement. However, extreme readings can also signal an impending reversal, requiring careful consideration of other technical indicators and market context.

Hypothetical Example

Consider two hypothetical stocks, Stock A and Stock B, over a six-month period.

• Stock A: Started at $50, and after six months, its price is $65.
• Stock B: Started at $100, and after six months, its price is $80.

To calculate the 6-month price momentum for each:

Stock A Price Momentum:
( \frac{$65 - $50}{$50} = \frac{$15}{$50} = 0.30 ) or 30%

Stock B Price Momentum:
( \frac{$80 - $100}{$100} = \frac{-$20}{$100} = -0.20 ) or -20%

In this example, Stock A exhibits strong positive price momentum (30%), indicating it has been a "winner." A momentum investor might consider buying Stock A, expecting its upward trend to continue. Stock B, with negative price momentum (-20%), is a "loser." An investor might avoid Stock B or consider a short position, anticipating its downward trend to persist. This simplified illustration demonstrates how quantitative measures of past performance guide potential investment decisions based on momentum. It is important to remember that past return on investment does not guarantee future results.

Practical Applications

Price momentum is a widely applied concept in various facets of investing and market analysis:

• Quantitative Investment Strategies: Many quantitative funds and hedge funds build sophisticated models that incorporate price momentum as a key factor for security selection and portfolio optimization. These models often combine momentum with other factors like value, quality, or volatility.
• Factor Investing: Momentum is recognized as a persistent "factor" in asset returns, similar to value or size. Investors can gain exposure to this factor through specific momentum-focused exchange-traded funds (ETFs) or mutual funds. For instance, the MSCI Momentum Indexes are designed to reflect the performance of companies exhibiting higher momentum characteristics.¹⁴, ¹⁵, ¹⁶
• Trend Following: Price momentum is fundamental to trend following strategies, where the objective is to profit from sustained price movements. Traders enter positions when a trend is identified and exit when it shows signs of weakening or reversing.
• Relative Strength Analysis: Analysts use price momentum to compare the performance of one asset against another or against a benchmark. This helps identify which assets are outperforming or underperforming, guiding asset allocation decisions.
• Market Timing: While challenging, some investors use momentum indicators to inform market timing decisions, attempting to increase exposure to markets or sectors showing strong positive momentum and reduce it in those with negative momentum.
• Risk Indicators: Sudden shifts or extreme readings in price momentum can sometimes serve as early warnings for potential market reversals or increased volatility, prompting a review of existing positions. The Federal Reserve, for example, monitors various economic indicators, including those that might show underlying momentum in price pressures or market activity.¹⁰, ¹¹, ¹², ¹³

Limitations and Criticisms

Despite its historical efficacy, price momentum is not without limitations and criticisms. A significant concern is the potential for "momentum crashes," where strategies based on momentum experience sharp and sudden drawdowns. These crashes often occur after prolonged periods of strong market performance or during market reversals, such as the period following the dot-com bubble or the 2008 financial crisis.⁵, ⁶, ⁷, ⁸, ⁹ During such events, past losers can rebound dramatically while past winners collapse, leading to substantial losses for momentum-oriented portfolios.

Another criticism relates to the high turnover often associated with momentum strategies. To capture short-to-medium-term trends, portfolios must frequently buy and sell securities, which can lead to significant transaction costs and impact returns, especially for large institutional investors. Furthermore, the underlying economic rationale for why price momentum persists is still debated. While some attribute it to behavioral biases like investor underreaction to news or herding behavior, others struggle to reconcile it with strict efficient market hypotheses.⁴

The reliance on past performance also means that momentum strategies are inherently backward-looking. While they assume past trends will continue, there is no guarantee, and sudden shifts in market conditions or new information can quickly invalidate existing trends, leading to unexpected drawdowns. Critics also point out that the implementation of momentum strategies in live funds often falls short of theoretical backtested performance due to these practical challenges and costs.³

Price Momentum vs. Relative Strength

While often used interchangeably, "price momentum" and "relative strength" refer to closely related but distinct concepts in financial analysis.

Price Momentum primarily focuses on an asset's absolute past price performance over a specific period. It measures how much an asset's price has changed, typically as a percentage, to determine if it has been trending positively or negatively. The calculation is straightforward, comparing a current price to a past price. An asset has positive price momentum if its price has been rising and negative if it has been falling.

Relative Strength, on the other hand, measures an asset's performance relative to another asset, a group of assets (like an industry sector), or a broader market index. It is concerned with which assets are outperforming or underperforming their peers or a benchmark, rather than just their standalone price change. While relative strength often incorporates an element of price momentum, its core insight is comparative. For example, an asset might have positive absolute price momentum, but negative relative strength if the broader market is rising even faster.¹, ²

The confusion between the two arises because strong relative strength often implies strong price momentum, and vice versa. However, an investor focused purely on price momentum might buy a stock that is going up, even if it is underperforming its industry group. Conversely, a relative strength investor might sell a stock that is going up but less quickly than its peers, opting for a stronger performer. Both are forms of trend following strategies but with different comparative lenses.

FAQs

What is the primary goal of using price momentum?

The primary goal of using price momentum is to identify assets whose prices are likely to continue moving in their current direction, allowing investors to potentially profit from the persistence of existing trends. It helps in making timely investment decisions based on observed price behavior.

Is price momentum a form of fundamental analysis?

No, price momentum is a core component of technical analysis. Unlike fundamental analysis, which examines a company's financial health, industry, and economic factors, technical analysis focuses solely on past price movements and trading volume to predict future price action.

How often should price momentum be calculated?

The frequency of calculating price momentum depends on an investor's trading strategy and time horizon. Short-term traders might calculate it daily or weekly, using periods like 1-3 months. Longer-term investors might use monthly or quarterly calculations over periods ranging from 6 to 12 months, or even longer, to capture more enduring trends.

Can price momentum be used for all types of assets?

Yes, price momentum can be applied to various asset classes, including individual stocks, bonds, commodities, currencies, and even broader market indices. The underlying principle that trends tend to persist applies across different financial markets.

Does positive price momentum guarantee future gains?

No, positive price momentum does not guarantee future gains. While historically it has been shown to be a persistent phenomenon, all investment strategies carry inherent risks. Prices can reverse unexpectedly, leading to "momentum crashes" where past winners turn into rapid losers. Effective diversification and risk management are crucial when employing momentum strategies.