Momentum investing is a trading strategy that is designed to take advantage of the continuance of existing market trends. It refers to the practice of buying securities that have been on an upward trajectory and selling them when they show signs of peaking. The core belief in momentum investing is that trends—whether they are bullish or bearish—tend to persist for a certain duration, providing opportunities for traders to capitalize on these movements.
Key Takeaways
- Definition: Momentum investing is about catching and riding existing market trends.
- Market Momentum: This refers to the capacity of a price trend to maintain itself over time.
- Rules-Based Approach: Momentum investing often relies on a rigorous set of rules grounded in technical indicators that provide guidance on when to enter and exit trades.
- Professional Adoption: Despite its potential rewards, few professional fund managers use momentum investing, favoring deeper financial analyses based on fundamental factors instead.
The Mechanics of Momentum Investing
Going Long and Short
Momentum investors generally "go long" on assets that are trending upwards. For example, if a stock has exhibited consistent growth over several weeks or months, an investor might buy shares with the expectation that the price will continue to rise. Conversely, they may choose to "short" or sell off assets that are showing downward trends, anticipating further declines.
This strategy was prominently illustrated during the U.S. stock market’s bull run that started in March 2009 and ended in December 2018, where many momentum investors made substantial gains by staying within this upward trend.
Historical Context and Influence
The strategy of momentum investing is often attributed to Richard Driehaus, a notable fund manager and businessman, who played a significant role in its popularization. His advocacy for momentum strategies has inspired many investors and spawned various adaptations and methodologies over the years.
Momentum Investing Methods
Momentum investing typically follows a set of explicit rules based on technical indicators. Here are several commonly employed methods:
Moving Averages
Many momentum investors use moving averages (MAs) to generate trading signals. A typical method involves utilizing two different MAs—such as the 50-day and the 200-day moving averages. A buy signal occurs when the shorter 50-day MA crosses above the longer 200-day MA, while a sell signal is generated when the opposite occurs.
Sector Rotation
Some traders engage in buying sector exchange-traded funds (ETFs) with the strongest momentum and shorting those with the weakest performance. This strategy often requires quick adjustments to positions as market strength ebbs and flows among different sectors.
Cross-Asset Analysis
Cross-asset analysis refers to examining relationships between different asset classes to identify momentum trends. For instance, some equity traders monitor Treasury yield curves to find signals for entering or exiting equity positions. When the yield on the 10-year Treasury bond exceeds that of the 2-year bond, it may signal a bullish phase for stocks, while an inverted yield curve could point to bearish sentiment.
CAN SLIM Strategy
The CAN SLIM approach is a hybrid of momentum and fundamental analysis created by William O'Neil, founder of Investor’s Business Daily. It emphasizes strong earnings growth, sales performance, and price momentum while establishing a set of criteria for buy and sell decisions based on both fundamentals and momentum indicators.
The Debate Around Momentum Investing
While momentum investing has its proponents, it remains a contentious topic within the investment community. Many professional managers argue that fundamental analysis, focused on metrics like discounted cash flow (DCF) valuations, offers more reliable insights for long-term investing.
However, various academic studies, including a noteworthy 1993 analysis published in the Journal of Finance, demonstrated that strategies built around buying past winners and selling past losers yielded significant outperformance over the broader market.
Moreover, the American Association of Individual Investors (AAII) has found that strategies like CAN SLIM can outperform the S&P 500 over both short and long-term periods, indicating that momentum can, at times, defy conventional investment wisdom.
Technical Indicators Used in Momentum Trading
Several technical indicators are invaluable for momentum traders:
- Relative Strength Index (RSI): Measures the speed and change of price movements to identify overbought or oversold conditions.
- Rate of Change (ROC): Calculates the percentage change in price from one period to another, helping gauge momentum.
- Stochastics: Following the closing price in relation to a price range over a specific period, giving insight into current momentum.
- Moving Average Convergence Divergence (MACD): An interplay between two moving averages provides buy/sell signals based on market momentum.
Conclusion: Should You Try Momentum Investing?
Momentum investing can be a lucrative strategy for those willing to adopt a disciplined, rule-based approach to trading. However, it is essential to remain cautious, as like all investment strategies, it carries inherent risks. Potential investors should consider factors such as liquidity, trading volume, and their own risk tolerance while carefully evaluating each security in their portfolio.
In essence, momentum investing represents a dynamic and intricate approach to the financial markets, one that offers both opportunities and challenges in the quest for capitalizing on market trends.