Momentum Trading Strategy (How To Trade It – Backtest)

Last Updated on October 19, 2022 by Oddmund Groette

You may be familiar with the popular stock trading adage: “Buy low and sell high.” Some traders, however, attempt to buy high and sell higher using the momentum strategy. Wondering what the momentum strategy is?

Momentum trading strategy is the practice of buying and selling assets according to the recent strength of price trends. Traders who use the strategy aim to buy securities that have been showing an upward price trend and short-sell securities that have been showing a downward trend.

In this post, we take a look at the momentum strategy, and at the end of the article, we make a backtest of the strategy

What is a momentum strategy?

Momentum trading strategy is the practice of buying and selling assets according to the recent strength of price trends. That is, it uses the strength of price movements as a basis for opening positions. Traders who use the strategy aim to buy securities that have been showing an upward price trend and short-sell securities that have been showing a downward trend.

The strategy is based on trend following and supports the idea that a trend is likely to continue until it is shown to have reversed. Though not the first person to use the strategy, Richard Driehaus is considered the father of momentum investing because he used the strategy to run his funds. He believed that more money could be made by buying high-flying stocks and selling them higher than by buying underpriced stocks and waiting for the market to re-evaluate them. He would often buy winners and sell losers and keep rotating his money into new winners.

The momentum trading strategy is based solely on technical analysis, as it is not concerned with a company’s operational performance but the momentum of the stock price at any given time. Momentum traders seek to analyze and understand the trend and strength of the trend in the market — in other words, to determine the level of price momentum in the market. Some may also check investors’ sentiments and the direction of the broad market.

They do that using different technical indicators to identify trends and gauge the strength of the trend, as well as sentiment indicators that show the general mood of the market. In a bullish market, they seek to buy the top-performing stocks and ETFs, and in a bearish market, they seek to short-sell the weakest stocks.

The rationale behind the momentum strategy?

The momentum strategy is based on the idea that if there is enough force behind a price move, it will continue to move in the same direction. In other words, if a trend is well-established, it is likely to continue, as more traders and investors try not to miss out on the price move. The strategy takes advantage of investor herding mentality, also known as FOMO (fear of missing out), which drives the price in one direction.

To break it down a bit, when a stock reaches a higher price, it usually attracts more attention from traders and investors, which pushes the market price even higher. The price would continue to rise until something happens to make people start dumping the stock. Once enough sellers are in the market, the momentum changes direction and will force the stock price down. Short-sellers would take advantage of the downside momentum to sell short and cover at a lower price.

Essentially, the momentum trading strategy seeks to take advantage of market volatility by taking short-term positions in stocks going up and selling them as soon as they show signs of going down. The investor then moves the capital to other stocks showing momentum. So, the market volatility is like waves in the ocean, with the momentum trader sailing up the crest of one, only to jump to the next wave before the first wave crashes down again.

It is important to note that momentum trading is not a long-only strategy. Some traders use a combination of both long and short approaches. Taking long positions in stocks with high upside momentum and short positions in stocks with a high downside momentum.

Do momentum strategies work?

With a good trading plan, momentum strategies work. If they don’t work, various investment funds won’t be using them for asset location. The momentum approach is based on inertia, which is the tendency for an object to remain in its state of motion until acted on by a force. In the case of the stock market, a stock6’s price continues to trend until it is forced to reverse and establish momentum in the opposite direction.

Traders use the momentum strategy to profit from either buying or selling short stocks when they are in a strong momentum, as evidenced by the strong price advance or decline (as the case may be) over a period of time. Momentum investing is typically short-term investing, as traders are merely looking to capture part of the price movement in a trend. For example, if the S&P 500 rises in one month, you go long at the close and hold it for one month. At the end of the next month, you look at the performance again and stay long if the performance is positive or you sell if the trend was negative.

Research has shown that momentum trading has an edge in the stock market but only when used over a short timeframe, such as 3-12 months, and rotating every month. A typical momentum trading strategy could go like this:

  • You select a universe of stocks
  • You use a momentum indicator to identify trends and assess the strength of the trend in the various stocks
  • You take long positions in stocks with the strongest upside momentum and if you like, take short positions in the stocks with the strongest downside trend
  • When the momentum of the trend shows signs of weakening, such as a divergence between price action and the movement of momentum indicators, you exit your positions before the trend reverses.
  • You then rotate the capital to a new set of stocks showing the best momentum in either direction and take the corresponding position.

In summary, momentum trading is all about identifying how strong the trend is in a given direction and taking a position to take advantage of the expected price change and close the position when the trend starts to lose its strength. Momentum traders don’t necessarily attempt to find the top and bottom of a trend; instead, they focus on the main body of the price move. They aim to exploit market sentiment and herd mentality that pushes the price in one direction.

Momentum strategy indicators

Momentum trading is based on technical analysis. There are many technical analysis indicators traders use to determine the momentum of an asset’s price. These are the most commonly used in momentum trading:

  1. Trend lines: Trend lines are used in technical analysis to delineate the direction of the trend. A trend line is drawn along successive swing points on a price chart. In an uptrend, it is drawn along the swing lows, while in a downtrend, it is drawn along the swing highs. The slope of the trend line shows the strength of the price momentum. Stocks with steep uptrend lines are for long positions while the ones with steep downtrend lines are for short positions.
  2. Moving averages: A moving average continuously calculates the average of the price as new data is printed. Traders use moving averages to identify the prevailing trend while eliminating much of the market “noise” that comes from small, insignificant price fluctuations. A stock’s price consistently remaining at or above a moving average indicates the existence of an uptrend. The opposite is true for a downtrend.
  3. Stochastic: This is a momentum oscillator that compares an asset’s most recent closing price to the prices over a chosen period of time — when the closing price is near the high of the price range for the time period, the momentum is high and when the closing price is near the low, this indicates a downward trend. The values range from 0 to 100, with values above 50 indicating a rising upside momentum and values below 50 indicating a rising downside momentum. However, a reading below 20 indicates oversold conditions in a market that may lead to a market reversal to the upside, while a reading above 80 indicateds overbought conditions and the potential for a bearish reversal.
  4. The Average Directional Index (ADX): The ADX is a very popular indicator used by momentum traders. It shows the existence of a trend and the strength of a trend but does not show the direction of the trend. ADX values range from 0 to 100, and values below 25 indicate a ranging, or directionless, market, while a reading above 25 indicates the existence of a trend. The higher the reading, the stronger the trend. So, an ADX reading of 40 indicates a stronger trend than an ADX reading of 30. Traders who use this have to combine it with other indicators, such as moving averages, to identify the trend direction.
  5. Price action: Some traders also use price action analysis to spot stocks with high momentum. One common method price action momentum traders use is checking for new highs and new lows. Stocks that are making new highs are showing high upside momentum, while the ones making new lows are showing strong downside momentum. So, a trader can go long stocks that are making new highs and short the ones that are making new lows.

Other popular momentum trading indicators include the rate of change (ROC), moving average convergence divergence (MACD), and relative strength index (RSI).

ETF momentum strategy

The momentum strategy is not only used in trading stock. You can also use it to trade ETFs and rotate between assets or sectors. Sector rotation, which involves moving your capital from one market sector to another depending on the performance, works well with momentum strategies. For example, you can rotate capital between the Health Care Select Sector SPDR Fund (XLV) and the Technology Select Sector SPDR Fund (XLK). That is, if the economy is booming, you can buy XLK and sell when a recession sets in and move the money to XLV because healthcare is often recession-proof and tend to perform better than the tech sector during a recession.

Even during a bull market, traders can rotate from one sector ETF to another based on their momentum. To be a successful momentum trader, they need to be able to identify the best sectors quickly and accurately. They can use any of the many screeners out there to select the right ETF to buy at any time Here are the basic steps they tend to follow:

  • They identify the ETFs you are interested in.
  • They check the ETFs trading close to or above their yearly highs.
  • They sort the chosen ETFs from highest to lowest based on momentum to see which are doing the best.
  • They buy the best performing three ETFs and monitor them monthly
  • Each month, they rank the ETFs again according to their momentum
  • If any of the purchased three has fallen out of the top three, they sell that one and use the money to buy the new ETF that makes it to the top three.

A better way to apply the momentum strategy is in asset class rotation, such as tactically switching between the equity market and the bond market when one is performing better than the other. That is, when the stock market is in a bull market, you can buy the S&P 500 Index ETF (SPY) and sell when a bear market comes and move your capital to Treasury bond ETF (TLT) until the next equity bull market.

This S&P 500 and Treasury bond rotation has been used for a long time for tactical asset allocation based on momentum and rotation. Treasury bonds offer a safe haven when the equity market is in trouble. When there is a bear market in stocks, investors move their money to the bond market until normalcy returns in equities. This is why this type of sector rotation is so popular and is based on the momentum strategy.

Momentum trading strategy – backtest

A backtest with trading rules and settings is coming shortly.

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