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 trading strategy is?
Momentum trading strategies are 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 several backtests of momentum strategies.
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. Driehaus 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. He was part of the Turtle trading experiment.
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 (or whatever asset they are analyzing), and in a bearish market, they seek to short-sell the weakest stocks.
The momentum effect is well documented in academia (in the stock market). Research shows that the performance of the latest 1-3 months performance tends to continue for a few months more. However, the momentum effect doesn’t seem to work as well for shorter and longer periods. Thus, the momentum effect is relatively short-term.
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 will likely 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 forces 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 use 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 force. In the case of the stock market, a stock’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 some time.
Momentum investing is typically short-term, as traders merely look 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:
- 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.
- Moving averages: A moving average continuously calculates the price average as new data is printed. Traders use moving averages to identify the prevailing trend while eliminating much of the ” noise ” 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.
- 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.
- 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.
- Price action: Some traders also use price action analysis to spot stocks with high momentum. One common method of price action momentum traders uses is checking for new highs and new lows. Stocks that are making new highs show high upside momentum, while those making new lows show strong downside momentum. So, a trader can go long stocks that are making new highs and short the ones that are making new lows.
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.
Here are a few examples of sector rotation momentum strategies:
- Sector Trading Strategy (Backtests And Examples)
- A Monthly Momentum Strategy In ETFs (EEM, SPY, And TLT)
- RSI Momentum Strategy (Does RSI Momentum Work? Backtest)
- TLT vs SPY – Bond Rotation Strategy – (Monthly Momentum Strategy)
- Is Meb Faber’s Momentum and Trend-Following Trading Strategy in Gold, Stocks, And Bonds Still Working?
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 identify the best sectors quickly and accurately. They can use any of the many screeners 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. 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 – does it work?
In this section of the article, we will backtest three momentum trading strategies.
We start by looking at a price action momentum trading strategy:
Price action momentum trading strategy backtest (stocks)
We make the following trading rules and settings:
- When the close crosses above the 100-day high of the close, we go long at the close.
- When the close crosses below the lowest close in the last 100 days, we sell at the close.
Let’s backtest this simple momentum strategy on S&P 500 since 1960 until today:
There are only 41 trades, but the strategy has almost kept with buy and hold despite spending just 65% of the time in the market. Some performance facts:
- 41 trades
- The average gain per trade is 10%
- CAGR (annual returns) is 5.7% (buy and hold is 6.9%, not including dividends)
- The Win rate is 69%
- Profit factor is 7
- Max drawdown is 25% (buy and hold drawdown is 55%)
- Risk-adjusted return is 8.8%
Let’s look at the performance of the same strategy on the German DAX index:
The CAGR is 7.2% – slightly below the buy and hold strategy of 7.9%. However, the strategy has been flat recently, but DAX has yielded low returns over the last few years.
Price action momentum trading strategy backtest (crypto)
Let’s backtest a price action momentum strategy similar to the above but still different. These are the trading rules:
- When the close crosses above the 25-day high of the close, we go long at the close.
- When the close crosses below the 25-day high of the close, we sell at the close.
We backtest Bitcoin. This is what the equity curve looks like:
The trading statistics and performance metrics read like this:
- 179 trades
- The average gain per trade is 2.35%
- CAGR is 55.7%
- Time spent in the market is 14%
- Risk-adjusted return is 400.4% (risk-adjusted return formula)
- Profit factor is 2.4
- Max drawdown is 23%
We believe this is a pretty good strategy (so far, at least)! The buy-and-hold return is 58%, but the max drawdown has been a gut-wrenching 83%.
We also have a video of the Bitcoin strategy:
Sector rotation momentum strategy ETFs
Our third and last backtest in this article looks at a rotation strategy that uses monthly momentum to determine which asset to be long the next month. The strategy is also an example of a sector rotation strategy backtest.
The strategy measures the performance of four ETFs: SPY (S&P 500), TLT (long-term Treasuries), EFA (developed stock markets ex. USA), and EEM (emerging markets).
The trading rules and settings are like this:
- It’s based on monthly quotes in the ETFs SPY, TLT, EFA, and EEM.
- We rank all four ETFs every month based on last month’s performance/momentum.
- We go long the ONE ETF with the best performance the prior month (it doesn’t matter if negative or positive return).
- Hold for one month and rinse and repeat (or continue being long the same instrument).
The logic and trading rules are easy to understand, but it requires some problematic code to backtest the strategy successfully (you can purchase the code and logic for all free articles – including this momentum rotation backtest).
If we type in the trading rules into Amibroker (please read our Amibroker review), we get the following equity curve from 2002 until today:
The strategy fired on all cylinders last year until it created havoc. Not only did we have lower stock prices in 2022, but bonds had one of their worst years ever (and hence stocks dropped).
The strategy had the following statistics and performance metrics:
- The average gain per trade is 1.31%
- Annual returns of 10.1% (what is a good CAGR)
- A win rate of 58% (how to calculate win rate in trading)
- Max drawdown of 44% (what is max drawdown in trading)
- Profit factor of 1.5 (profit factor calculator)
2022 was terrible because the winners in the past month turned out to be the losers the next month – the opposite of the previous two decades.
The performance illustrates the problem with all trading strategies: nothing lasts forever, and the world changes.
Because of this, we prefer strategies based on a shorter time frame – swing trading – and we hold positions for substantially fewer days than in this post: average holding time is just a few days (single digits).
List of trading strategies
We have written over 1000 articles on this blog since we started in 2012. Many articles contain specific trading rules that can be backtested for profitability and performance metrics.
The code for all three backtested momentum trading strategies is included in the package.
The trading rules are compiled into a package where you can purchase all of them (recommended) or just a few of your choice. We have hundreds of trading ideas in the compilation.
The strategies also come with logic in plain English (plain English is for Python traders).
For a list of the strategies we have made, please click on the green banner:
These strategies must not be misunderstood for the premium strategies that we charge a fee for:
Momentum trading strategy video
We made a video that summarizes the main findings in this article:
FAQ momentum trading strategy
Let’s end the article with a few frequently asked questions:
Is momentum trading a good strategy?
It depends on many factors. For certain assets, it works better than others. For example, stocks are prone to mean reversion, while in the crypto world, momentum has (so far) worked well.
Which indicator is best for momentum trading?
There is no best or worst in trading. It would help if you backtested to find out what works and what don’t. One indicator might be good for S&P 500, while another is useless for bonds.
Is momentum trading the most profitable?
In stocks, probably not. In crypto, perhaps yes. Markets are constantly changing and only a backtest determines if momentum trading is profitable for the asset you are looking at.
Which indicator shows momentum in a stock?
There are many momentum indicators: RSI, MACD, and ADX, to name a few. However, we prefer to use price action instead of indicators.
Which are the most popular momentum indicators?
RSI, MACD, and ADX are among the most popular momentum indicators. We believe these indicators work much better as reversal indicators, but other traders might find them more valuable than we do. We prefer to look at price action to measure momentum (where the price is compared to N-days ago).
How do you identify bullish momentum?
We prefer to look at price action to measure momentum (where the price is compared to N-days ago).
Can this momentum strategy be improved?
We are not oracles, and we are pretty sure there are traders out there who can improve this strategy. Do you have any ideas on how to improve it? If so, please comment below or drop us an e-mail.