4 Examples of Momentum Investing
You can take many different approaches to investing in the stock market. You can stick with the classic ‘buy low, sell high’ strategy, or dabble in options trading to bring in more immediate income. The strategy you choose should reflect your long-term investing goals and what you consider a comfortable risk level. One strategy that seems to defy the odds year after year is the momentum investing strategy. Learn how it works, look at some of the benefits and downsides, and review a few examples of this strategy in action to see if it’s right for you.
- Momentum investing is a technical investing strategy.
- Momentum investors buy high and sell low.
- This strategy requires detailed technical research and consistent evaluation of the market.
- It can make you a lot of money, but requires a lot of time.
What Is Momentum Investing?
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Momentum investing is a system for buying securities. Essentially, you buy stocks that are doing well (as evidenced by an upward trend for three to 12 months) and sell stocks that are doing poorly (as evidenced by a downward trend for three to 12 months). While this might seem simple, it’s actually a complex, rules-driven strategy that requires an enormous amount of research and time.
There are many different subsets of momentum investing that use slightly different rules and approaches, but overall, momentum investors consider five elements before making a trade:
- Equity selection: Historically profitable equity selections are those that are super liquid and high volume. You want steady, easy-to-track securities that aren’t likely to change direction dramatically or suddenly.
- Timing risk: Momentum trading carries some inherent risks, which you must consider before jumping on. Limit risk by ensuring there’s truly a trend, regularly watching the charts for signs of reversals, and moving quickly to close negative positions before incurring substantial losses.
- Entry timing: Establish entry as quickly as possible. The earlier you get in on a trend, the more money you stand to make as others jump on and drive up the price.
- Position management: Think through your holding period. The longer you wait to close your position, the more likely you are to miss the peak.
- Exit points: Watch your indicators closely as the price continues to drive up. As soon as you see a plateau or other potential reversal indicator, it’s time to exit and close your position.
How Does the Momentum Investing Strategy Work?
To be a successful momentum investor, you have to follow the rules of the strategy and spend lots of time reviewing technical charts. The momentum stock strategy uses technical indicators exclusively as opposed to fundamentals or values indicators. Common technical indicators used by momentum investors include:
- Trend lines: Most momentum traders obsessively study stock charts. The trend lines, or the lines that connect the points on the chart, indicating upward or downward trends, are an easy way to see if a security is heading north or south over time.
- Moving averages: A moving average smooths out the constant fluctuations in a security’s value by taking the average over a set period of time (anywhere from a few minutes to days to weeks). Looking at the moving average can help momentum investors see if there’s a consistent upward or downward trend without the distraction of minute-by-minute price fluctuations.
- Stochastic oscillator: This indicator compares a security’s most recent closing price to prices over a set period of time (like the moving average, you can use a range of time periods). A closing price close to the high price point signifies a positive trend, while a closing price close to the low price point signifies a negative trend.
- Average directional index: The ADX is a favorite indicator among momentum investors. It determines both the existence of a trend and the strength of that trend by calculating the contraction or expansion of the equity’s price range over a set time frame.
All of these indicators help momentum investors know whether it’s time to buy or sell. Momentum investing takes advantage of market volatility by closely monitoring it and reacting to shifts in established trends. Other investors’ emotions-driven decisions can also help momentum investors decide whether to purchase (or sell) a security.
While the rules and specifics for timing and price can be complex, the basic steps to execute momentum investing are simple:
- Identify trend. Use your indicators to identify a positive or negative trend.
- Move on trend. Once you’ve found a consistent trend that looks like it’ll continue, make your move. Sell securities that are trending down and purchase securities that are trending up. If you sell, use the cash from the sale to invest in upward trending securities.
- Exit when signs of a reversal appears. Once your money is in an upward trend, carefully track the trajectory and make your exit as soon as you see signs of a reversal.
Advantages of Momentum Investing
Momentum investing does provide quite a few benefits to those investors who choose to use the strategy, like:
- High profits over a short time: Most investors close their positions quickly, sometimes even within the same day as the purchase. This leads to the potential for significant profits in a short time.
- Leveraging volatility: Since you’re watching the indicators closely, you’re tracking volatility and reacting to it in real time and to your advantage.
- Use other people’s emotional investments: Non-momentum traders might simply jump on a bandwagon because they see everyone else is doing it. You can harness that emotional investing and, using your indicators, closely track when to jump off the wagon to maintain a profit.
Disadvantages of Momentum Investing
Despite its potential upsides, it’s important to consider all the potential negatives before choosing to go with the momentum investing strategy:
- High fees and taxes: Momentum investing requires a high volume of trades. Depending on how your brokerage is organized, this could result in some steep management fees. You’ll also have to watch for capital gains taxes for every profit you make.
- Time consuming: This investing strategy takes a tremendous amount of time and dedication. When you have open positions, you have to watch your technical indicators pretty much non-stop to ensure you don’t miss the moment to exit.
- Only works well in a bull market: Momentum investing really only yields high profits in a bull market. It doesn’t perform nearly as well in a bear market.
- Tied to market success: Often, the top players in the market are all part of the same one or two industries. If these collapse or face a sector-wide setback, your entire strategy could come crashing down.
Momentum Strategy Examples
Y ou can apply the momentum strategy in many different ways. Each momentum investor has different indicators they rely on more than others and varied benchmarks for when to jump on a trend and when to jump off. Here are four relatively common momentum strategies for you to consider:
Two Moving Averages
With this strategy, investors use two moving averages as their primary buy or sell indicators. The first is a shorter term moving average, for example, over 50 days. The second is a longer term moving average, for example, over 200 days. Momentum investors compare the two and look for overlap. Generally, if the 50-day moving average crosses above the 200-day moving average, it’s a sign to buy. If the 50-day moving average crosses below the 200-day moving average, then it’s time to sell.
This strategy is a bit more complicated. It uses ETFs exclusively rather than other types of securities like traditional stock shares. With this momentum strategy, you take a long position on a specific sector ETF with the strongest momentum while simultaneously shorting the sector ETF with the weakest momentum. You can do this with more than one ETF in your long and short position as well.
Cross Asset Analysis
With cross asset analysis, you use an indicator from one asset field to assess potential trends in other areas of the market. For example, some momentum investors like to review the Treasury yield curve and use it as their primary technical indicator for when to enter or exit a position. With this indicator, a 10-year Treasury yield above the two-year yield generally means buy, while the opposite, a 10-year Treasury yield below the two-year yield, means sell.
Some momentum investors only enter positions with stop-loss orders to protect their interests. Stop-loss orders specify that the investor’s broker should buy or sell a certain stock when it reaches a set price point. Stop-loss orders can help those momentum investors who don’t have the time to sit and stare at stock charts and wait for the perfect moment to enter or exit a position and still yield a profit. The stop-loss order protects your interests while still allowing you to earn a payoff.
Momentum investing is a viable investing strategy, but best suited to those who have a solid knowledge of reading and using technical indicators and who have lots of time to review ongoing market fluctuations and volatility. Consider exactly which type of strategy works best for you before embarking on this whirlwind style of investing.