What Are Momentum Stocks
Momentum trading is an investment strategy that’s based on pricing trends. It combines rules-based trading with technical indicators to help traders determine when to enter and exit a particular holding. Since price trend is key to a momentum trader, just about any asset can be used for this type of strategy, including ETFs, funds, and more, but momentum stocks are the most common.
But finding the right trades is the key.
That’s because momentum trading as a strategy is all about buying an asset that is on its way up in price and selling it at its peak before the trend reverses. The goal is simple: buy low and sell high. But, unlike traditional investors, momentum traders use a wide range of technical indicators to predict price trends, identify stocks set to appreciate in the short term, and create a systematic trading strategy for their portfolio. They need to have a plan to inform them when they buy the asset, what price changes they are looking for, under what conditions they will sell, and what they expect the outcome to be.
But, for all this to function profitably, the trader needs to reliably find the best momentum stocks for their strategies, uncovering the true opportunities from the thousands of options available on the stock market at any given time.
What is Momentum?
The dictionary defines momentum as “the force of energy exhibited by a moving body,” the driving force that pushes something forward. It is the same when it comes to investing. A momentum stock has force behind it, pushing its price higher and higher. Check out Momentum Trading Explained to learn more.
Ideally, a momentum stock isn’t volatile, jumping up in price and then dropping back down. Traders are looking for assets that are consistently and continuously going up for days, if not months, at a time. It’s these uptrends that momentum investors are watching for, evaluating the price momentum against their chosen momentum indicators to determine when a rising price shifts from pure volatility or noise to a bonafide trend in the stock market. Then they act, entering their trade with a pre-set plan for what data will trigger their exit.
Trading momentum stocks is equal parts science and art. Traders use technical analysis to identify stocks well-positioned to breakout and hit new 52-week highs. To improve decision-making and take some of the subjective nature out of momentum tradings, investors can create rules for portfolio management and automate buying and selling.
Understanding Momentum Indicators
The process of momentum investing can be boiled down to several steps: choosing the right momentum stock, entering the trade at the right time, sticking to the plan while you’re holding the asset, and knowing when to exit to achieve the results you are looking for. Each step in this process uses momentum indicators or technical trading data points that, when analyzed, can show a savvy investor the underlying price trend. Read the 5 Best Momentum Indicators for Retail Investors to go deeper on these technical analysis tools.
Several of the most popular momentum indicators are:
Price Change: Simply put, this indicator looks at how much the price of a target stock has changed over a set period of time.
Moving average: Moving average smooths price trends and can be helpful when tracking price trends over long periods.
Rate of Change (ROC): This indicator measures how quickly the price of a given stock changes, allowing momentum traders to spot shifts in the stock market based on how fast or slowly they are playing out.
Relative Strength Index (RSI): How overvalued or undervalued is a given stock compared to the broader market and its peers?
Stochastic Oscillator: Often used to spot undersold and oversold conditions, a stochastic oscillator uses closing prices over time to evaluate price divergence. Read Stochastic Oscillator Explained.
Moving Average Convergence Divergence (MACD): MACD is a trend-following momentum indicator that tracks the divergence between two moving averages.
How to Find Momentum Stocks
As mentioned, there are several vital steps to any momentum investing strategy. Find the right stock, get into the trade at the right time, stick to your plan while you hold the stock, and exit when your indicators tell you it is time. Similarly, unpacking the first step in this process — finding momentum stocks — can be broken down into a series of steps borrowed from technical investing.
Select your investment universe
When choosing momentum stocks, the sky is the limit. Do you want to look for potential targets across the entire S&P 500, or would you prefer to drill down and focus on specific industries or sectors? Narrowing your total universe of potential investments to just the 25 largest tech companies, the fastest-growing stocks over the last year or another subsegment can make the decision-making process easier by enabling you to use more targeted momentum indicators best suited for that niche.
Choose your momentum indicator
The indicator that is best suited for your investment strategy will likely depend
(1) on the stock or segment you are targeting and
(2) on your goals and expectation for your trade.
Moving averages, ROC, a stochastic oscillator, and other momentum indicators can be powerful tools in helping the trader analyze the universe of potential trades, but the “best” one will vary from investor to investor and situation to situation.
Choose your look-back period
How far back do you want to pull data when deciding on a potential momentum stock? The look-back period is the time frame over which you measure momentum for your investment universe. Some traders prefer a year, others a month, and others just a few days. It depends on the volatility of the investment universe and the broader stock market.
Decide on your selection criteria
Once you have your momentum indicators chosen, you’ll need to decide how you want to use them to measure the stock price trends you’re looking for. Momentum traders often create rules for their indicators — only buy when RSI is below 30, for example, or choose the top 2 absolute performers based on cumulative return — to inform their trades. No momentum trade should be managed on the fly; these selection criteria must be chosen on the front end and used to outline the entire trade from start to finish.
A wide variety of technical indicators are available on Composer
Select your rebalance frequency
The most successful momentum traders know how often to re-evaluate and rebalance their portfolios as momentum trends change. But there is no hard and fast rule about what frequency is best. Frequent rebalancing improves portfolio responsiveness to changing market conditions, but it can also increase transaction costs. On the flip side, less regular rebalancing saves on trading costs but can leave your assets exposed to changes in the broader stock market that might impact your momentum trades.
Once these decisions have been made, it is time to backtest your assumptions, gather your initial results, and refine them as needed. You might get far too many potential stocks to start and need to narrow down the list, or you might not find any that fit your criteria. This part of the process is about honing your strategy to uncover potential momentum stocks and those best positioned to put up new highs.
If you’re interested in building your own momentum strategies, learn more with our Step-By-Step Guide to Building Momentum Trading Strategies.
Automated trading vs. using a stock screener
Many momentum investors will use simple stock screeners to gather their data and track their indicators, but there are drawbacks to this approach. When developing a strategy, investors should consider volatility (how much price movement has there been in a given stock over a given period of time), drawdowns (how much has the investment declined over past performance), and trading costs (the execution costs that can eat into returns). Composer’s backtesting software assesses these criteria and gives investors the data to make better decisions.
Screeners can flag snapshots of these data points, but they are not capable of actively monitoring and adjusting on the fly as the stock market ebbs and flows. That’s because screens must be updated manually and reviewed every time you need to update your positions. On the other hand, automated trading can implement trades based on pre-set rules, eliminating the need to constantly update screens, and keeping investors ahead of the game. Check out 5 Momentum Strategies to Consider, or create a Composer account today to build your own.
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