By Gaurav Singh
Momentum trading is a popular short-term trading paradigm. It involves identifying a change in asset price and then taking positions in the direction of price change with the expectation that the price will continue to move in that direction.
In this blog, we will understand more about momentum trading.
- What is Momentum Trading?
- How does Momentum Trading Work?
- A Simple Momentum Trading Strategy
- Risks Involved
- How to Start Momentum Trading?
What is Momentum Trading?
In Physics, the term Momentum is used to define an object’s quantity and direction of motion. Similarly in financial markets, the momentum of an asset is the direction and speed of price change of the asset in the market.
Momentum trading is the strategy where you analyse assets in the short-term and buy the assets whose price is rising. Then sell those assets when the price seems to have peaked, thereby making a profit. The basic idea is that if there is enough force behind a price move, the price will continue to move in that direction.
The underlying principle for momentum trading is to “buy high and sell higher”, and vice-versa.
Richard Driehaus, a famous investor, is considered as the Father of Momentum Investing and his investing techniques have become the basics of Momentum Trading. Driehaus believed in selling the losers and letting the winners ride while reinvesting the money from the losers in other stocks that were beginning to show momentum.
Momentum trading is a bit different than the usual value investing paradigm of “buying low and selling high”. Over the years momentum trading strategies have proved to be profitable in the financial markets.
In practice, momentum trading is seen to be more popular than “buying low and selling high”. This is because you buy an asset which is already moving up. You do not have to buy an undervalued asset and wait for the market to reassess that particular stock so that your investment finally turns profitable.
Another advantage of using momentum trading is that there is a potential for high profits over a short period. Since you are leveraging the market's volatility to your advantage, the momentum trading ultimately boils down to chasing the market performance to maximize your investment.
How does Momentum Trading Work?
The momentum trading strategies find opportunities in short term asset price movement. The assumption is that if the price of an asset is increasing, it will continue to increase in absence of other factors.
Think of momentum trading as a moving car. The speed is slow as you start moving forward. This is when you identify a stock which is increasing in price.
As the car accelerates, the speed increases. If you have identified the stock and purchased it, your investment now starts to grow.
On seeing a red traffic signal, the car decelerates and the speed reduces. This is similar to when you exit your position at a profit on seeing a momentum loss in the asset price.
Types of Momentum
There are two types of momentum trading. Time-series momentum and cross-sectional momentum.
- Time-series momentum is the performance of an asset compared to its own historical performance. Time-series momentum is identified by a certain percentage profit threshold, and the assets exceeding the threshold are bought.
- Cross-sectional momentum is the performance of an asset compared relative to other assets in a portfolio. This can be the top ten best-performing assets being bought and the bottom ten performing assets being sold.
The momentum strategies are not applied solely to equities. They can be implemented on Futures and the Treasury markets too!
Factors Affecting the Momentum
The short-term price change of an asset is affected by a number of factors. Some of these factors are as follows.
- Fundamental factors: If a company posts any good or bad fundamental news, the stock price of that company will move in a particular direction for the next couple of days. Ideally, the market should discount this information instantaneously, but for major announcements, the news percolation takes time.
- News events: The momentum of an asset is also affected by certain news events. In the case of a scheduled news event like an earnings announcement, this effect is smaller since the news is expected. In case of an unscheduled news event like a merger announcement, the momentum change is greater.
- Market volatility: Market volatility is a major factor to consider when trading using momentum. Since a position is made after the asset price starts moving, high volatility means that there is potential room for the price to increase further so that you can make a profit.
- Herding effect: The tendency of traders to follow the majority is more prominent in bearish markets. The herding effect reduces the profit margin for momentum traders.
How to Detect Momentum?
The detection of a momentum trading opportunity is very important so that you can time your entry position in an asset. To detect momentum, you can either use technical indicators or use statistical analysis.
- Technical Indicators: The various technical indicators to detect momentum are:
- Momentum Indicator: An oscillating indicator used to confirm the direction of the asset’s price action.
- RSI Indicator: An oscillating indicator to find whether an asset is overbought or oversold.
- Moving Averages: These are indicators to spot emerging trends in the asset price.
- Breakout Indicator: These indicators can be used to explicitly identify the breakout in price or volume.
- Statistical Analysis: You can use statistical analysis like the Hurst Exponent test. The Hurst Exponent relates to the autocorrelation of the asset and can be used to identify if the asset is trending or not. Here you will get to know what AutoCovariance and AutoCorrelation functions are.
The various methods to detect momentum are covered with detailed examples in the momentum trading strategies course on Quantra.
For complex trading strategies, you can even combine signals from these indicators to obtain a more reliable momentum detection algorithm.
You can read more about Five Indicators To Build Trend-Following Strategies.
A Simple Momentum Trading Strategy
Let’s study a simple example of a momentum trading strategy using moving averages. Here you will see the implementation of the famous golden cross and death cross algorithm. This algorithm uses two moving average lines.
The two moving averages are the slow-line, or the slow-moving average with a larger lookback period, say 200. And the fast-line, or the fast-moving average with a smaller lookback period, say 50.
The golden cross is a chart pattern which indicates a bullish price trend. A golden cross occurs when the fast-line crosses the slow line in an upward direction (i.e. from below to above).
A death cross is indicative of a bearish trend. This occurs when the fast-line crosses the slow line in a downward direction (i.e. from above to below).
A simple strategy can be built to long the asset when a golden cross occurs, and short it when a death cross occurs.
The Python logic for finding signals using the moving averages is as follows.
You can try this strategy on Blueshift by clicking the button below!
The strategy returns since 2015 are as follows.
The momentum strategy outperforms the benchmark. The strategy performance can further be improved by implementing proper risk management techniques and fine-tuning of the parameters.
It is interesting to note that the long-only strategy implementation (entering position only on a golden cross) is far more profitable than the strategy where short positions are taken on death cross. The long-only strategy returns are shown below.
Risks Involved in Momentum Trading
Like all trading strategies, momentum trading is not without risks. Some of the risk factors to be careful are listed below.
- Timing of entry and exit: The momentum trading strategies are extremely time-critical. If the entry position is taken too late, the investment might turn out to be a loss-making one. Similarly, if the slowdown of momentum is incorrectly identified and a position is exited too soon, you lose out on potential gains even after identifying the opportunity.
- High transaction cost: Since this type of strategy identifies short term opportunities, the number of overall trades can be high when compared to the long term value investing or buy and hold strategies. This leads to a greater transaction cost.
- Time-consuming: The trader has to monitor the opportunities closely and needs to be updated with all relevant news for the asset being traded.
- Market sentiment: Empirically it is seen that momentum trading works best in bullish markets. This is because of the human psyche to herd together in adverse conditions (bear market). The herding results in a decrease in profit per trader for the same trading opportunity. This effect is also clearly seen in the two strategy results above.
- Trend-reversal: The momentum strategy assumes the trend will continue in the same direction. Sometimes however the trend reverses and this strategy fails.
Adequate risk management techniques need to be implemented when you trade the momentum trading strategy in live markets. Proper position sizing and trailing stop-loss can be used to reduce the strategy drawdowns and limit your market exposure.
How to Start Momentum Trading?
To start trading using momentum, you need to first learn in detail about the momentum trading concepts and how to detect momentum, the factors affecting momentum and the risks associated with this type of investment pattern.
A good place to start is the free Forex trading course where the cross-sectional momentum strategy is implemented and integrated with Blueshift, a platform to create, backtest and live trade your strategies.
To study about momentum trading in detail, you can check out the Quantra course on momentum trading strategies where the concepts are explained with examples and worked out in Python code. More trading strategies are taught in the course which can help you capture the different types of momentum using indicators, implement momentum trading using asset futures and event-driven opportunities. The momentum trading strategies are implemented on Blueshift and templates for IBridgePy are provided too!
For advanced concepts in momentum trading, you can check out this detailed webinar conducted by Nitesh Khandelwal.
Disclaimer: All investments and trading in the stock market involve risk. Any decisions to place trades in the financial markets, including trading in stock or options or other financial instruments is a personal decision that should only be made after thorough research, including a personal risk and financial assessment and the engagement of professional assistance to the extent you believe necessary. The trading strategies or related information mentioned in this article is for informational purposes only.