Momentum investing is a strategy designed to harness the continuance of prevailing market trends. By purchasing securities that are already gaining value, and selling them at their perceived peak, investors can capitalize on momentum’s steadfast trajectory.
Key Takeaways
- Capitalize on prevailing market trends for sustained returns
- Momentum mirrors the capacity of price trends to continue
- Implements stringent rules based on technical indicators for market entries and exits
- Professional investors often leverage fundamental factors and value indicators
Understanding Momentum Investing
Momentum investing centers on both long positions—on instruments with upward-trending prices—and short positions—on those heading downward. Believing that trends can endure over extended periods, momentum investors profit by riding these trends from inception to completion.
Prominent for formalizing momentum investing, Richard Driehaus popularized the approach despite not being its original creator. His strategies earned accolades and drove the trends of the U.S. stock market from 2009 through late 2018.
Momentum Investing Techniques
Momentum investing often relies on technical indicators, enforcing rules for market entry and exit. Investors may utilize longer-term moving averages (MAs), such as the 50-day and 200-day averages. For instance, a 50-day MA crossing above a 200-day MA is often a buy signal, while crossing below is a sell trigger.
Investors may also deploy sector-based strategies where the focus lies on long positions in sector ETFs with strong momentum and short positions in the weakest ones. Some may even perform cross-asset analysis, examining the Treasury yield curve to determine buy or sell signals for equities.
Other approaches, like the CAN SLIM system, intertwine momentum and fundamental factors, spotlighting securities with substantial earnings, sales momentum, and follow technical signals for timely buy and sell decisions.
The Momentum Investing Debate
Despite the momentum investing’s proven success, only a few professional investors robustly adopt it. They often favor analysis rooted in discounted cash flows (DCFs) and other fundamental factors for predictable outcomes, aligning with the efficient market hypothesis.
Evidence supporting momentum investing includes a 1993 study in the Journal of Finance showing noticeable returns, and findings by the American Association of Individual Investors (AAII) indicating CAN SLIM’s efficiency in outpacing the S&P 500.
Key Momentum Indicators
Effective momentum trading leans on several indicators including the relative strength index (RSI), price rate of change (ROC), stochastics, and moving average convergence divergence (MACD).
Formula for Market Momentum
Market momentum leverages the equation:
M = V - Vx
Where:
V: The latest price Vx: The closing price x number of days ago
Market Psychology in Momentum Trading
Momentum traders tap into herd mentality, greed, and FOMO, often propelling bull markets higher than anticipated. Similarly, panic selling during downturns can amplify crashes.
By adhering to momentum’s principles and strategies, savvy investors can possibly navigate market trends more effectively, shaping better-informed investment portfolios.
Related Terms: technical analysis, moving averages, RSI, ROC, herd behavior.
References
- Tanous, Peter J. Investment gurus: a road map to wealth from the world’s best money managers. Penguin, 1999.
- Investors’ Business Daily. “About Us”.
- UCLA Anderson Review. “Momentum Investing: It Works, But Why?”
- Jegadeesh, Narasimhan, and Sheridan Titman. Returns to buying winners and selling losers: Implications for stock market efficiency. *The Journal of Finance,*Vol. 48, No. 1. 1993. Pp. 65-91.
- Lutey, Matt, and David Rayome. Live Out of Sample Testing of CAN SLIM Stock Selection Strategy. *Journal of Accounting and Finance,*Vol. 22, No. 2. 2022. Pp. 1-7.
