A Step-By-Step Guide to Building the Best Momentum Trading Strategies
Momentum trading is a tried-and-true method among investors for a good reason: it works. By focusing on buying assets on the way up and selling them at the top, savvy investors can take advantage of this market anomaly and target momentum stocks that are more likely to rise on short-term uptrends. Momentum trading can capitalize on stock price movements that traditional “buy low, sell high” investors might miss out on.
But assembling a momentum trading strategy is easier said than done. How exactly can investors identify the assets that are best positioned to take advantage of uptrends? How can you ensure those assets have reached “the top”? And how can you assemble a reliable rules-based portfolio around these short-term trends?
It’s all about watching price action in the stock market. Momentum is different than discretionary trading, which considers the pros and cons of trading at a particular moment rather than basing trades on preset parameters.
A momentum stock or ETF isn’t one that jumps up one day and falls back down to its previous price the next. These are assets that are consistently and continuously going up for days, if not months, at a time. Momentum traders are watching these price trends closely, using techniques borrowed from technical analysis to determine when a price move becomes a trend, indicating a more significant shift in the stock market. Then, on the flip side, they’re watching the opposite trend unroll to know when it is time to sell before a pullback.
How Momentum Trading Works
Although momentum investment strategies can take time to build and refine, at their core, they are reliant on several critical variables:
Choosing the right assets to trade
Timing each trade to minimize overall risk
Getting into each trade “on time”
Maintaining discipline over position sizes and timelines
Knowing when to exit
Successful momentum traders need to identify the assets set to break out by looking at chart patterns to find the individual stocks and ETFs that are best positioned to experience price swings in the months ahead. But that is only half of the process. Risk management is a critical part of momentum trading as a way to maximize returns by minimizing losses due to volatility. Some investors use stop-loss rules, while others rely on regular rebalancing and position limits. After all, the price changes that drive these investment strategies can quickly come back to bite you if that price swing turns into an extended downtrend and you haven’t protected your positions.
Once you have decided which assets to focus on, you’ll need to identify trends by looking at past performance (e.g., 52-week highs, 20-day price return). Assets showing the strongest signals based on technical indicators rise to the top of the list, with the best potential for gains. Depending on your trading style, your exit strategy for each of these trades might depend on short-term strength or anticipated downside risk. Whatever the plan, savvy momentum traders plan precisely what the “end” of each trade will look like before making any moves. You need to know specifically at which point you will take profits and when you will choose to exit with a loss. If momentum trading sounds appealing to you, check out Reasons Why Momentum Investing Works to understand the financial basis for this investment style.
Using Composer to Build a Momentum Trading Strategy
Fortunately, the Composer App makes building your momentum strategy easier. Let’s use Big Tech Momentum as an example of how someone can develop their own momentum strategy.
Developed by us at Composer, every month, this strategy invests in the two “big tech” stocks that have shown the best performance over the past month. This includes household names like Amazon, Apple, Microsoft, Google, Meta, and more, all the companies driving our modern tech economy.
The nice thing about Big Tech Momentum is that it actively identifies the momentum stocks within big tech. From the list of potential companies, the two with the highest 20-day cumulative return are selected for the portfolio. At the monthly rebalance, the strategy re-evaluates all the names and selects the top performers again. For momentum traders, Composer’s technology makes it easy to add assets and select the technical indicators you will use to make decisions about your entry and exit strategy.
Here are the steps you can take to build your own momentum strategy:
1. Select the investment universe you want to target
Momentum investors typically focus on stocks and ETFs due to their liquidity, but commodities, currencies, and other instruments are also fair game for these investment strategies. Research has shown momentum trends are profitable in many financial markets. Common investment universes include:
Stocks: The entire equity asset class is at your disposal. Select a large group like the S&P 500 or a subset like Big Tech.
ETFs: Exchange Traded Funds are a good way to capture price movement across an entire industry, sector, or asset class.
2. Select a momentum indicator
Once you have chosen an asset class to target, it is time to select the momentum indicator that you want to use to analyze those stocks or ETFs. And the list of potential technical indicators is long. Check out the 5 Best Momentum Indicators for Retail Investors to learn more.
Some investors focus on the Moving Average when charting out the price trends of their trades. In contrast, others prefer the Exponential Moving Average, which is weighted to give greater significance to recent price action. A Stochastic Oscillator takes things a step further, comparing recent prices for a stock to a range of prices over a set period, making it another valuable tool in a momentum trader’s arsenal. Other indicators include the Relative Strength Index (RSI), which measures the speed and magnitude of a security's recent price changes, and Rate of Change (ROC), which measures the percentage change in price between the current price and a previous price.
Which one is the best momentum indicator for you? It depends on your trading style and the type of assets you are trading.
The most basic measure, the moving average, can be helpful when tracking price trends over long periods.
Exponential moving average:
Weighted toward more recent action, this indicator can be handy when trying to spot early breakouts before they get priced into the market.
General information about price changes over time can be valuable, but volatility within a set period matters to momentum traders too. The focus on volatility makes stochastic oscillator analysis particularly valuable.
Relative strength index (RSI):
As a momentum indicator, RSI can be a valuable way for traders to determine whether a given asset is overvalued or undervalued.
Rate of change (ROC):
Tracking price changes on a simple up or down basis, ROC can be a quick and easy way to spot winners and losers over a set period. Assets that are part of an uptrend will return a result above zero, while those on a downtrend will be below zero.
3. Backtest your lookback period
Risk Management when momentum trading involves many moving parts. First, the trader needs to understand where the price trends are on the overall uptrend / downtrend cycle. Are prices near the top, or do they have room to run? Second, they need to use that information to plan their investment strategy. When will they get in, under what conditions will they exit, how will they protect their positions, and when is an exit at a loss an acceptable outcome?
Backtesting potential trades can predict what might (emphasis on might) happen to a given stock, ETF, or other asset in the future, with research suggesting an optimal lookback period of eight to nine months. However, none of this is set in stone, as the “best” lookback period from a predictive standpoint is constantly evolving. For example, from the late 1980s through 2008, 12 months was the best performing lookback period among momentum traders. However, following the Financial Crisis through 2019, a three-month lookback was best.
In short: There is no trend, just a collection of trends that are constantly changing and evolving. Rather than isolate any one lookback period as the “best,” an effective approach is to test a range of lookback periods to determine which one offers the most stable trend signaling for the asset class and period you are reviewing. Composer allows for quick and easy testing of these lookback period variables.
4. Choose a rebalance cadence
Rebalancing is part of the secret sauce of any momentum trading strategy. Traders must know how often they need to re-evaluate and rebalance their portfolios as momentum trends change.
Unfortunately, there is no one answer. Some traders rebalance multiple times a day (aka day traders watching intraday price action), while others look to move on a weekly, monthly, or even quarterly cadence. Some longer-term traders consider annual rebalancing for their momentum trades, though that is typically less common given the focus on volatility over the holding period. One example on an institutional level is the iShares MSCI USA Momentum Factor ETF, which tracks an index of U.S. large- and mid-cap stocks exhibiting “relatively higher price momentum.” iShares rebalances MTUM semi-annually, given that its market isn’t particularly volatile and large-cap price changes tend to happen slowly.
The upside to frequent rebalancing is that it improves portfolio responsiveness to changing market conditions, which can boost overall returns when done carefully. But, it also increases transaction costs, which are a set expense no matter the potential return improvements.
Create a Composer account today to begin building and testing momentum strategies. Or, if you want to keep it simple, invest in a pre-made strategy from the Composer team.
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