Understand Momentum Investing: Strategies and Benefits

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Momentum investing is a strategy of buying assets whose prices have been rising and selling (or shorting) assets whose prices have been falling, on the premise that recent price trends tend to persist for a while before they fade. A momentum investor does not ask whether a stock, ETF, futures contract or currency pair is cheap, only whether its price is already moving strongly in one direction and shows signs of continuing.

How momentum investing works

A momentum strategy has three parts: a measure of the strength of a price move, an entry rule and an exit rule. It works on individual stocks, market and sector ETFs, futures, forex or any instrument with a liquid price history, going long on upward-trending assets and, where shorting is allowed, short on downward-trending ones.

The goal is to stay with a trend until it ends. For example, the U.S. stock market broadly trended up from 2009 until December 2018; a momentum investor would not have predicted the end of that run but would have exited once their signals turned.

The momentum formula

The basic measure of market momentum compares today’s price with the price a set number of periods ago:

M = V − Vx

where V is the latest price and Vx is the closing price x days ago. A positive M means the price is higher than it was x days earlier; a negative M means it is lower. The larger the absolute value, the stronger the move.

Because M is expressed in price units, it cannot compare a $20 stock with a $400 stock. The rate of change (ROC) solves this by converting the difference into a percentage:

ROC = (V − Vx) / Vx × 100

Worked example (hypothetical)

Assume Stock A closes at $55 today and closed at $50 twenty trading days ago, while Stock B closes at $210 today versus $200 twenty days ago.

• Stock A: M = 55 − 50 = $5; ROC = 5 / 50 × 100 = 10%
• Stock B: M = 210 − 200 = $10; ROC = 10 / 200 × 100 = 5%

Stock B has the larger raw momentum, but Stock A has twice the percentage momentum. A strategy that ranks assets by strength would favor Stock A. The lookback (20 days here) is an assumption: a different window can produce a different ranking.

Methods of momentum investing

Momentum investors tend to follow strict, predefined rules rather than discretionary judgment. Common approaches include:

Moving average crossovers. Two moving averages of different lengths generate signals. A widely cited pair is the 50-day and 200-day: the 50-day crossing above the 200-day is a buy signal, and crossing back below is a sell signal. Some investors use even longer averages to filter out short-lived moves.

Sector rotation. The investor ranks sector ETFs by price momentum, goes long the strongest and shorts the weakest, then rotates as the rankings change. This is relative, or cross-sectional, momentum.

Cross-asset signals. Some equity traders treat the Treasury yield curve as a signal. A 10-year yield above the 2-year is read as a buy signal for stocks, and an inverted curve, with the 2-year above the 10-year, as a sell signal, partly because that spread has a record as a recession predictor.

Hybrid systems. CAN SLIM, popularized by William O’Neill, founder of Investor’s Business Daily, screens for strong quarterly and annual earnings per share growth among other criteria. Its reliance on fundamentals leads some to call it impure momentum, but earnings and sales momentum tend to accompany price momentum, and its buy and sell rules are largely technical.

Whatever the method, a strategy that trades often needs liquid instruments that can be entered and exited without large price impact.

Indicators momentum traders use

Beyond moving averages and ROC, the most common momentum tools are listed below. They measure the speed of price change, not its cause, so most systems combine more than one:

• Relative Strength Index (RSI): an oscillator from 0 to 100 that compares the size of recent gains with recent losses. See the RSI formula and how to use it.
• Stochastics: compares a closing price with its range over a set period.
• MACD (moving average convergence divergence): tracks the gap between two exponential moving averages and a signal line.

The psychology behind momentum

Momentum strategies profit from crowd behavior. Herd mentality, greed and fear of missing out can push a rising market beyond what fundamentals justify, while fear and panic can turn an ordinary selloff into a crash. The aim is to ride these moves without being the last buyer at the top.

Evidence and controversy

Under the efficient market hypothesis, past prices should not predict future returns, so persistent momentum profits are an anomaly. Even Eugene Fama, a leading proponent of efficient markets, has acknowledged that momentum patterns appear in long-run market data.

The landmark study, Jegadeesh and Titman (1993) in the Journal of Finance, found that buying recent U.S. stock winners and selling recent losers produced significantly higher near-term returns than the market from 1965 to 1989. A 2022 out-of-sample review of CAN SLIM, citing the American Association of Individual Investors, reported that it beat the S&P 500 over trailing five-year, 10-year and longer periods.

Skeptics, including many fundamental managers, argue that stock selection through discounted cash flow analysis and other fundamentals gives more predictable long-term results. Fund manager Richard Driehaus, often called the father of momentum investing, built his career on the opposite view, though he did not invent the approach.

Limitations and risks

• Sharp reversals. Trends can end suddenly, and a position entered late in a move absorbs the full reversal. A predefined stop-loss order is the usual defense.
• Misread signals. Choppy, sideways markets generate crossovers and oscillator readings that reverse quickly, producing repeated small losses.
• Trading costs. Frequent entries, exits and rotations add commissions, spreads and, in taxable accounts, short-term gains.
• Lag. Indicators built on past prices confirm a trend after it has started and signal an exit after it has turned.
• Position size. Because volatility is high, sizing each trade to a fixed account risk matters; a position size calculator handles the arithmetic.

Momentum vs. related ideas

Momentum vs. value investing. Value investors buy assets they consider underpriced relative to fundamentals, often after declines. Momentum investors buy what is already rising, regardless of valuation.

Absolute vs. relative momentum. Absolute (time-series) momentum asks whether an asset is up over its own past. Relative (cross-sectional) momentum asks whether it is up more than its peers. Sector rotation uses the second.

Momentum investing vs. momentum indicators. An indicator such as RSI or ROC is a measurement. Momentum investing is a full strategy that uses such measurements alongside entry, exit and risk rules.

The Bottom Line

Momentum investing suits traders willing to follow strict, predefined rules and act on price trends without asking whether an asset is cheap. Research supports the approach, yet sharp reversals, false signals in choppy markets, indicator lag and frequent trading costs can erode returns. Liquid instruments, predefined stop-loss orders and position sizing tied to a fixed account risk give momentum traders the best chance to ride a trend without absorbing the full reversal.