Momentum trading revolves around the idea that assets that have performed well in the past will continue to perform well in the future. It is a trading strategy where investors buy assets whose prices are already rising, and sell them when it appears they have reached their peak.
Momentum-style investors hold the belief that ongoing trends will persist in the same direction due to the momentum already propelling them forward.
What Is Momentum Trading
“Momentum” is the empirically observed tendency for rising asset prices to rise further, and falling prices to keep falling. The existence of momentum is a market anomaly, and it has been suggested that the anomaly is driven by behavioral biases of investors.
“The existence of momentum gives rise to a simple and intuitive strategy: buy winners and sell losers,” says Marco Santanche, a quant strategist and author of the newsletter Quant Evolution. “Because they tend to stay on top or bottom for a while.”
The strategy has gained popularity in recent times, and investors can now access momentum trading through ETFs such as iShares MSCI USA Momentum Factor ETF (MTUM) and Vanguard US Momentum Factor ETF (VFMO).
When Does Momentum Perform Well?
While momentum trading may appear intuitive, its performance is not uniform under all circumstances.
As pointed out by Santanche in his newsletter Quant Evolution, “It is a strategy that tends to perform better in expansionary times. The persistence of performance, especially when observed on longer time frames, is not symmetric. Winners do tend to continue performing well, but the story is usually a bit more complicated for losers.”
Short selling losers poses various challenges. “Sharp declines can be followed by technical rebounds, or end up burning the stock value much faster than the persistence period,” explains Santanche. “Although we are normally trading both sides, the distance in performance can be reduced by such rebounds or quick comebacks in losers.”
For this reason, expansionary times are generally more favorable: buy winners and sell “worse winners”, which basically means that the market is generally green, as noted by Santanche.
Key Principles of Momentum Trading
Price Trends Matter: Momentum traders rely heavily on price trends. The strategy assumes that assets exhibiting positive momentum will continue to rise, while those with negative momentum will continue to decline.
Relative Strength: Momentum is often assessed in relative terms, comparing the performance of one asset to another or to a benchmark index. This relative strength analysis helps investors identify assets that are outperforming their peers.
Time Horizons: Momentum trading typically involves shorter time horizons compared to other strategies. Investors may hold positions for weeks or months rather than years, as the strategy aims to capture the ongoing momentum of a trend.
Benefits of Momentum Trading
Potential for Profits: When successfully implemented, momentum trading can lead to significant profits by capitalizing on existing trends and market dynamics.
Adaptability: Momentum strategies can adapt to changing market conditions. Investors can shift their positions based on evolving trends, potentially avoiding prolonged periods of underperformance.
Quantitative Analysis: Momentum trading often incorporates quantitative analysis and statistical models, allowing for systematic decision-making and reducing reliance on subjective judgment.
Investment Considerations and Risks
Overvaluation Concerns: Assets with strong momentum may become overvalued, leading to a potential “bubble” that could burst if market sentiment changes.
Risk of Reversals: Momentum trading relies on the continuation of trends, but trends can reverse unexpectedly. Investors should be vigilant and have risk management strategies in place.
Illiquidity: Assets may experience periods of illiquidity, making it challenging to buy or sell quickly.
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