Momentum investing is based on a simple observation: stocks that have performed well tend to continue performing well, and stocks that have performed poorly tend to keep underperforming. This guide explains how to harness momentum to identify winning stocks and build a trend-following portfolio.
What is Momentum Investing?
Momentum investing is a strategy that buys stocks showing upward price trends and sells (or avoids) stocks in downward trends. Unlike value investing, which looks for underpriced assets, momentum investing follows the crowd, betting that recent winners will continue winning.
The simple version: Buy high, sell higher. Momentum investors believe that trending stocks will keep trending. They buy stocks going up and sell them before they reverse.
Why Momentum Works
Academic research has consistently shown that momentum is one of the most persistent market anomalies. Several factors explain why momentum persists:
- Behavioral biases: Investors underreact to new information, causing gradual price adjustments
- Herding behavior: Investors follow each other, amplifying trends
- Confirmation bias: Rising prices attract more buyers, pushing prices higher
- Institutional flows: Large funds cannot move in and out of positions quickly
Key Momentum Indicators
1. Relative Strength
Compares a stock's performance to the overall market or its sector. A stock with high relative strength is outperforming its peers.
Example
Over the past 12 months:
- S&P 500 returned: +10%
- Stock ABC returned: +35%
- Relative strength: ABC outperformed by 25 percentage points
This high relative strength makes ABC a momentum candidate.
2. Price Rate of Change (ROC)
Measures the percentage change in price over a specific period. Higher ROC indicates stronger momentum.
3. Moving Average Crossovers
When shorter-term moving averages cross above longer-term averages (like the 50-day crossing above the 200-day), it signals positive momentum.
4. RSI (Relative Strength Index)
Measures the speed and magnitude of price movements on a scale of 0-100. Readings above 70 indicate strong momentum (though potentially overbought).
Momentum Investing Timeframes
Short-term Momentum (1-4 weeks)
Very active trading based on recent price action. Requires constant monitoring and quick execution. Higher transaction costs.
Intermediate Momentum (3-12 months)
The sweet spot for most momentum strategies. Research shows the 3-12 month lookback period captures the momentum effect most effectively.
Long-term Momentum (12+ months)
At longer timeframes, momentum tends to reverse. Stocks that have risen dramatically over 3-5 years often underperform going forward.
Typical Momentum Strategy
A standard momentum approach:
- Rank all stocks by 12-month return (excluding the most recent month)
- Buy the top 10-20% of performers
- Hold for one month, then rebalance
- Repeat monthly to stay in the strongest trends
Building a Momentum Portfolio
- Screen for momentum: Use 6 or 12-month returns to identify top performers
- Confirm the trend: Check that price is above key moving averages (50-day, 200-day)
- Diversify: Hold 20-30 positions across different sectors
- Rebalance regularly: Monthly or quarterly to capture new leaders
- Use stop-losses: Exit positions that break below key support levels
- Manage risk: Reduce exposure when overall market momentum weakens
Momentum and Other Factors
Momentum can be combined with other investment factors for potentially better results:
- Momentum + Value: Buy cheap stocks with improving price trends
- Momentum + Quality: Focus on high-quality companies in uptrends
- Momentum + Size: Small-cap momentum has historically been especially strong
Risks of Momentum Investing
- Momentum crashes: When momentum reverses, it can do so violently (2009, 2020)
- High turnover: Frequent trading leads to transaction costs and taxes
- Whipsaws: False signals in choppy, sideways markets
- Crowding: Popular momentum stocks can become overvalued and vulnerable
- Timing difficulty: Hard to know when momentum will reverse
Critical warning: Momentum strategies can experience severe drawdowns. In 2009, momentum suffered one of its worst months ever, losing over 30% in a single month as beaten-down stocks surged.
Momentum Stop-Loss Strategies
Because momentum can reverse suddenly, risk management is essential:
- Trailing stops: Exit if a stock falls 10-15% from its peak
- Moving average stops: Sell when price breaks below the 50-day moving average
- Relative strength stops: Exit when relative strength turns negative
- Time stops: Exit positions that have not made new highs in X weeks
Track Your Momentum Trades
Pro Trader Dashboard helps you identify momentum stocks, track your entry and exit timing, and analyze which momentum setups work best for your trading style.
Famous Momentum Investors
- Richard Driehaus: Pioneer of momentum investing, achieved exceptional returns
- William O'Neil: Creator of CAN SLIM strategy combining growth and momentum
- AQR Capital: Quantitative firm that extensively researches momentum
Summary
Momentum investing works because trends tend to persist longer than most people expect. By systematically buying winners and selling losers, momentum investors can capture market-beating returns. However, the strategy requires disciplined rebalancing, strict risk management, and the emotional fortitude to buy stocks at all-time highs. Combined with other factors like value or quality, momentum can be a powerful component of a diversified investment approach.
Ready to learn more? Check out our guide on contrarian investing for the opposite approach, or explore growth investing which often overlaps with momentum.