Momentum trading: What it is and how it works (2024)

Dictionary definitions of momentum often focus on the movement of a physical object.

On Wall Street, momentum trading mirrors that idea, with a twist or two along the way.

“Momentum investing is simply the art of identifying stocks with strong upward movement and buying them before they peter out,” said Peter Tanous, chairman emeritus at Lynx Investment Advisory. “As investment guru Richard Driehaus once put it, momentum trading simply means buying stocks that are going up rather than the ones that are going down. More famously, Driehaus said momentum trading is looking for stocks on the ‘new highs’ list rather than on the ‘new lows’ list.”

The trick, of course, is to buy stocks of companies with the fundamentals to continue rising. “That process involves doing the research and making decisions,” Tanous said. “The last thing you want to do is buy a stock that has risen dramatically and buy it at the top.”

Principles of momentum trading

Primarily, momentum traders focus on four key principles:

• Trend identification
• Risk management
• Monitoring
• Discipline

“Trends can be identified using technical analysis tools such as moving averages, among others,” said George Khoury, global head of education and research at Dubai-based CFI Financial Group. “While finding a trend is important, risk management is equally critical. Effective risk management involves stop-loss orders and position sizing to control potential losses.”

Additionally, continuous monitoring of positions and the market is necessary to detect changes in momentum or signs of trend reversals. “Discipline is also important when momentum investing as traders must detail a trading strategy and follow it regardless of their emotions,” Khoury added.

Identifying momentum stocks to buy

Investors can use various tools to find momentum stocks, such as screeners highlighting technical analysis data.

“Traders can also check price action and trend lines as well as use technical indicators while examining charts, like moving averages, relative strength index (RSI), moving average convergence divergence (MACD) and others,” Khoury said. “Moreover, traders can also look into chart patterns indicating trend changes. A global understanding of the market can also be helpful as monitoring the news, earnings reports and product launches can help detect catalysts that induce surges or declines.”

Use the analysis tools offered at your brokerage firm’s website for trends showing that a momentum stock is in play.

“For example, you could use your broker’s stock screening feature (assuming it has one) to identify stocks that have outperformed the by a certain percentage, are trading for well above their moving averages, or you can sort by other metrics,” said Matt Frankel, a certified financial planner (CFP) and stock market analyst at The Motley Fool.

Factors that drive momentum

The drivers behind momentum trading are fundamentally simple.

“Market experts often attribute [momentum] to market behaviors rather than complex technical or algorithmic factors: high prices attract buyers, and low prices attract sellers,” said Deiya Pernas, co-founder and analyst at Pernas Research in San Juan, Puerto Rico. “Despite its effectiveness, the exact reasons momentum trading continues to work remain somewhat of a mystery within academic circles.”

There are some tangible factors Main Street investors can lock into to get a better grip on momentum trading.

“The stock market represents a melting point of traders’ expectations relative to the dynamics of economic developments,” Khoury said. “Consequently, myriad factors exist capable of propelling an asset’s momentum.”

For example, economic data releases and robust earnings reports can drive sustained momentum in a stock’s price by influencing sentiment and growth potential. “Similarly, significant news events, such as mergers and acquisitions, partnerships or regulatory approvals, can trigger momentum in a stock as investors react to new information about the company’s prospects,” Khoury noted.

Risk management in momentum trading

Despite its potential for profits, momentum trading poses several challenges that traders need to be aware of, noted Scott McBrien, chief investment officer and founder of Stock Timing Tech in Scottsdale, Arizona.

These factors are at the top of that “risk list.”

• False breakouts and whipsaws: “Traders risk entering positions based on apparent momentum only to see the trend reverse quickly, resulting in losses,” McBrien noted.
• Market volatility: High volatility can lead to erratic price movements, making it difficult to accurately identify genuine momentum trends.
• Overbought and oversold conditions: Relying solely on momentum oscillators can result in false signals, especially in strongly trending markets.
• Behavioral biases: Traders may be affected by behavioral biases, such as overconfidence or confirmation bias, which can affect their decision-making.
• Transaction costs: “Frequent trading can result in significant transaction costs, eating into profits and reducing the strategy’s effectiveness,” McBrien added.

To overcome these challenges and succeed in momentum trading, traders can follow these tips:

1. Go with the flow: “Invest in the direction of the market,” McBrien said. “Also, set stop-loss orders. That gives you predetermined exit points for each trade to limit potential losses before entering the trade.”
2. Practice position sizing: Avoid risking a significant portion of your capital on any trade. “Don’t risk more than 1% on any given trade idea,” McBrien said. “That’s a simple discipline anyone can do if you know your exit strategy upfront. Buying and hoping is not a profitable strategy.”
3. Stay disciplined: Maintain emotional discipline and stick to your risk management plan, “even during periods of volatility,” McBrien added.
4. Adapt to market conditions: Be prepared to adjust your approach or even reverse your position based on changing market conditions and volatility levels.
5. Choose market sectors: “Opt for stocks in the top-three market sectors where money flows into,” McBrien advised. “I prefer to watch a small basket of stocks very closely instead of throwing spaghetti against the wall and seeing which pieces stick.”

Common momentum trading strategies

There are multiple momentum trading strategies that traders can follow.

• Breakout trading: “This strategy allows a trader to identify key levels of support and resistance and enter trades when the price breaks out above resistance or below support levels,” Khoury said.
• Moving average crossovers: A “crossovers” strategy involves observing the interactions of moving averages of different timeframes to generate buy or sell signals. For example, when a shorter-term moving average crosses above a longer-term moving average — often called a “golden cross” — it indicates that short-term momentum is accelerating.
• Relative strength analysis strategy: This method helps identify assets showing strength relative to their peers and enter trades toward this strength.
• Momentum oscillators strategy: This strategy identifies overbought or oversold conditions in the market, which refers to assets experiencing either excessive optimism or pessimism among investors. “Traders enter trades when these indicators signal a momentum reversal,” Khoury said.

These strategies can be complex for less-experienced traders, so it’s advisable to work with a professional money manager when deploying these trading moves.

“Each of these strategies offers its own advantages and challenges and has to be selected according to the trader’s style, preferences and risk appetite,” Khoury added.

Momentum trading versus other strategies

There are other ways to latch on to rising stock prices. Perhaps the most common is a traditional buy-and-hold approach, in which investors buy an index fund that tracks the entire market. Index funds are a low-cost way for investors to get exposure to all of the stocks that make up an index, such as the S&P 500. Long-term index investors indirectly benefit from momentum in individual stocks, but they generally don’t trade in and out of stocks or sectors in an attempt to follow the momentum.

For that, there is a momentum investing strategy called factor/style rotation.

“Here, large macro funds and investment firms are keenly watching interest rates versus inflation these days,” said Christina Qi, CEO of Databento, an on-demand market data platform. “In the event of a rate cut, it’s quite likely to see factor rotation that could see large correlated moves in whole sectors, like technology.”

Data from Thrivent show how various market sectors have performed in recent years as they go in and out of favor with investors:

Another strategy leans into intraday momentum, where traders use technical indicators on intraday prices to forecast a future move.

“These days, retail traders have cheap access to the data and market connectivity to build strategies that trade using these types of stock market predictors,” Qi said. “There are some caveats, however. For example, one difficult issue is that so-called algorithmic trading is very competitive as investors are trying to catch mispricings of market makers with better data, better models, more resources and lower commissions.”

The takeaway on momentum trading

Momentum trading allows traders to profit from asset price trends, but it requires careful risk management, discipline and adaptability.

“By understanding the strategies, challenges and tips outlined above, traders can navigate the world of momentum trading more effectively and improve their chances of success in the markets,” McBrien said.

Frequently asked questions (FAQs)