Momentum Trading Strategy

Momentum trading capitalizes on the tendency for winning stocks to continue winning and losing stocks to continue losing. It's one of the most researched and persistent market anomalies. [DEFINITION] Momentum Trading: A strategy that buys stocks with strong recent performance and sells (or avoids) stocks with weak recent performance, based on the tendency for trends to persist. ### The Momentum Effect [KEY] Academic research consistently shows that stocks with strong 6-12 month performance tend to outperform over the next 3-12 months. This contradicts efficient market theory but persists globally. **Why momentum works:** - Initial underreaction to news - Gradual information diffusion - Herding behavior - Confirmation bias ### Measuring Momentum **Price momentum:** - 12-month return (excluding last month) - 6-month return - Relative strength vs. market **Earnings momentum:** - Earnings surprise (beat/miss) - Analyst revision trends - EPS growth acceleration [FORMULA] Relative Strength = Stock Return ÷ Market Return over period [EXAMPLE] Stock returned 30% over 12 months while market returned 10%. Relative Strength = 30% ÷ 10% = 3.0. This stock has strong positive momentum. ### Momentum Trading Strategies **1. Price Breakout:** - Buy stocks making new 52-week highs - Focus on strong volume confirmation - Ride until momentum fades **2. Sector Rotation:** - Identify strongest sectors (XLK, XLE, XLF, etc.) - Rotate into top performers - Exit when sector momentum weakens **3. Dual Momentum:** - Compare asset class momentum (stocks vs. bonds) - Within winning class, select strongest stocks - Monthly or quarterly rebalancing [TIP] Combine price momentum with earnings momentum for stronger signals. Stocks with both price strength and positive earnings surprises tend to perform best. ### Momentum Entry and Exit **Entry signals:** - Stock breaking to new high on volume - Relative strength ranking in top 10-20% - Positive earnings momentum **Exit signals:** - Stock dropping from relative strength ranking - Breaking key support (50-day MA) - Sector momentum reversing [WARNING] Momentum works until it suddenly doesn't. Momentum crashes (sharp reversals) occur periodically, especially during market stress. Risk management is crucial. ### Momentum Crashes Historical momentum crashes: - 2009 market reversal: Momentum underperformed 50%+ - During sharp market turns, laggards surge, leaders fall **Protection strategies:** - Diversify across many momentum stocks - Use stop-losses - Monitor overall market trend - Reduce exposure during high volatility [EXERCISE] You screen for momentum and find 3 stocks: A returned 45% in 12 months, B returned 30%, C returned 60%. Market returned 15%. Calculate relative strength for each. Which is the strongest momentum stock? |ANSWER| A: 45%÷15% = 3.0x. B: 30%÷15% = 2.0x. C: 60%÷15% = 4.0x. Stock C has the strongest relative momentum at 4.0x the market return. [SCENARIO] You've been riding a momentum stock that's up 80% in 6 months. It suddenly drops 10% in one week but is still above its 50-day MA. Other momentum names are also pulling back. Is it time to sell? Not necessarily yet. A 10% pullback in a strong momentum stock is normal. The key is whether it holds support (50-day MA) and whether the broader momentum factor is still working. If the stock breaks the 50-day MA and relative strength is deteriorating, then exit. If it bounces and resumes the uptrend, hold. Don't panic on normal volatility.