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Momentum Stock Trading Explained

Whether new to stock trading or an old hand, you’ve probably heard of the term “momentum trading.” While it may not be the most well-known investment strategy, momentum trading holds an important position in the pantheon of classic investment methods, especially among savvy technical investors.

But what is momentum trading? At its core, momentum trading is a strategy that pays close attention to technical indicators in the stock market to determine which stocks to buy and sell. The idea is to buy winners and avoid losers. The stock market will have price uptrends and downtrends at any given time, and most investors working with a traditional investment strategy will make an educated guess about a company's far-future success or failure. This classic investing style usually involves making bets when the company is in its infancy, hoping it’ll become a breakout company over time.

Momentum trading rejects that trading style entirely. Instead, it uses momentum strategies to predict price trends in shorter time frames. Using technical analysis, momentum traders investigate uptrends to identify stocks currently on the rise with the goal of buying winners and selling them after they reach their peak. Then, with automatic trading algorithms or expertise, the momentum trader buys the stocks according to their pre-set rules. Typically, momentum traders start with defined price changes they’re looking for, setting guardrails for their trading. These momentum indicators are at the heart of momentum investing and are often followed to the letter.  

Understanding Momentum Indicators

Momentum indicators are the metrics used to track the performance of stocks. Often, they’re based on recent price movements and price action. While the period of time that momentum indicators will take into account may change, the main indicator is often the rise or fall of stock price. The most common momentum indicators are relative strength index (RSI) and moving average convergence divergence (MACD). Quick price swings are not what we’re looking for here; most skilled advisors looking to use momentum trading will look for steady upward market trends in a stock before purchasing.

Momentum indicators can also be negative. Often known as sell signals, there are plenty of times when a skilled investor practicing momentum trading will pull out of a stock because of its performance. Sometimes combined with stop-loss orders, negative momentum indicators are just as important as positive ones, often signalling trend reversals and a decrease in price momentum.

The Benefits of Momentum Trading

How profitable is momentum trading on average? Extremely profitable. A recent study that took into account stock prices and chart pattern data from as far back as 1801 reported that momentum investing delivers a 0.4% monthly return on investment on average.

However, the study also found that volatile markets affected momentum investing more than common investment strategies. The study's authors cited above identified seven decade-long periods where momentum investing wasn’t profitable. The first decade of the 21st century proved to be one of these periods. Therefore, momentum traders should carefully evaluate current and expected market volatility.

What’s more, momentum trading has begun to decline in overall effectiveness, and relative safety as market states get longer and longer. Long, predictable bull markets tend to generate worse returns for momentum traders than the first portion of a bull market. In other words, momentum effectiveness falls because the longer a bull market lasts, the closer we are to a quick decline into a bear market.

Trend Following vs. Momentum Trading

If you’re a savvy investor, you might think this sounds suspiciously like trend trading. However, these two strategies aren’t the same. While trend trading uses a similar overall philosophy to determine whether stocks will rise or fall, several key differences exist.

First of all, trend trading is a more macro-scale strategy, using trading platforms to look at the biggest possible picture. By looking at equities, fixed income, currencies, ETFs, and forex markets, trend trading is trying to accomplish the same goal in different arenas of the financial market. Momentum is more often focused on equities, although it can be applied to other asset classes like commodities, cryptocurrencies, and bonds.

Trend trading also focuses on time series momentum, which only considers each asset’s past financial history and returns. Momentum trading takes into account cross-sectional momentum, meaning that you can compare each asset to other assets in the same class.

Both types of investing can be extremely useful in their niches and, if used effectively, can be beneficial philosophies for stock trading.

Momentum trading is also different than swing trading. Swing trading typically looks at the gains that can be made by buying or selling at a particular moment. This naturally takes time into account. Momentum trading is almost completely focused on traders' rules and indicators. They won't buy or sell an asset if it doesn’t fit their pre-determined rules.

Risk Management in Momentum Trading

One of the greatest benefits of momentum trading and its greatest weaknesses is the rigidity of its own internal rules. For the strategy to work, you have to make non-negotiable rules for when you will consider a stock for a trade and when you will buy and sell it.

In other words, there’s no room for personal feelings in momentum trading. The rules are hard and fast. This rigidity is for the good of the strategy and allows the investor to make both long and short-term gains provided they did their research effectively. This also means that momentum investing can be a form of day trading, as long as the momentum indicators you’ve chosen to work with tell you to buy or sell in the right time frame.

Momentum trading can be a way to put guide rails onto your investment portfolio. How tight and defined your indicators are is up to you, especially when considering momentum trading alongside other investment strategies.

Momentum Trading with Composer

Composer was built to simplify and streamline the trading process for momentum traders of all sorts, and now is a good time to consider this investment strategy. Per the Composer investment team on the current market environment: “We are expecting continued dispersion in sector returns, and we prefer strategies like Sector Momentum, which have the potential to outperform a broad market portfolio.”

Our Sector Momentum strategy is diversified across all eleven stock market sectors, including health care, real estate, consumer staples, and more. However, as a momentum strategy, it invests monthly in just the three sectors that have seen the best performance over the past 200 days. It’s a good way to capture broad pricing trends across the market and take advantage of momentum trades across sectors.

Similarly, our Big Tech Momentum strategy invests every month in just the top two best-performing major tech stocks from the last month. That’s a list that includes household names like Amazon, Apple, Microsoft, Google, Meta, and more.

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