A momentum strategy is an investment strategy that aims to capitalize on the continuation of existing market trends. It is based on the idea that assets that have performed well in the past will continue to perform well in the future, while assets that have performed poorly will continue to underperform.
The basic principle behind a momentum strategy is to buy assets that have shown positive price momentum over a certain period (such as the past six to 12 months) and sell assets that have shown negative price momentum. This strategy assumes that trends will persist and that there is a behavioral bias among investors to follow trends rather than make contrarian bets.
Momentum strategies can be applied to various financial markets, including stocks, bonds, commodities, and currencies. The strategy typically involves periodically rebalancing the portfolio by selling underperforming assets and buying outperforming assets
Methods of Momentum Strategy
There are several methods that can be used to implement a momentum strategy in investing. Here are a few common approaches:
Absolute Momentum strategy
This method focuses on the absolute performance of an asset. It involves comparing the current price of an asset to its historical price over a specified lookback period. If the current price is higher than the historical price, the asset is considered to have positive momentum and is bought. If the current price is lower, indicating negative momentum, the asset is sold or avoided.
Relative Momentum strategy
This method compares the performance of an asset to other assets or a benchmark index. The relative strength of an asset is determined by comparing its price performance to that of other assets or a relevant benchmark over a specific period. Assets with the strongest relative strength are bought, while those with weaker relative strength are sold or avoided.
Dual Momentum strategy
This method combines absolute momentum and relative momentum. It involves comparing an asset’s absolute performance to its own historical performance (absolute momentum) as well as comparing its relative performance to other assets or a benchmark (relative momentum). Assets that exhibit positive absolute and relative momentum are favored, while those with negative momentum are sold or avoided.
Sector Rotation strategy
This method focuses on rotating investments among different sectors based on their momentum. It involves identifying sectors that have strong momentum and allocating a higher proportion of the portfolio to those sectors. This strategy assumes that sectors with positive momentum will continue to outperform in the future.
Time-Series Momentum strategy
This method looks at the trend in an asset’s price over different time periods. It involves comparing the performance of an asset over shorter-term and longer-term periods. If the shorter-term trend is positive and the longer-term trend is also positive, the asset is considered to have momentum and is bought. Conversely, if both trends are negative, the asset is sold or avoided.
It’s worth noting that these methods can be applied to different investment vehicles, including stocks, bonds, commodities, and currencies. The specific parameters and lookback periods used in each method can vary depending on the investor’s preference, risk tolerance, and the characteristics of the assets being considered.
Technical indicators used by momentum strategy Investors.
Momentum strategy investors often rely on various technical indicators to identify and confirm trends in asset prices. Here are some common technical indicators that can be used in momentum strategies:
Moving Averages (MA)
Moving averages smooth out price data over a specific period, providing a trend-following signal. Investors often use the crossover of shorter-term moving averages (e.g., 50-day) above longer-term moving averages (e.g., 200-day) as a bullish signal for buying, while the opposite crossover can be a bearish signal for selling.
Relative Strength Index (RSI)
The RSI is a momentum oscillator that measures the speed and change of price movements. It ranges from 0 to 100, with readings above 70 indicating overbought conditions and readings below 30 indicating oversold conditions. Momentum investors may look for assets with high RSI readings as potential sell candidates or low RSI readings as potential buy candidates.
The stochastic oscillator compares an asset’s closing price to its price range over a specific period. It also ranges from 0 to 100 and is used to identify overbought and oversold conditions. Crosses above the 80 level may indicate overbought conditions and potential sell signals, while crosses below the 20 level may indicate oversold conditions and potential buy signals.
Moving Average Convergence Divergence (MACD)
The MACD is a trend-following momentum indicator that shows the relationship between two moving averages of an asset’s price. It consists of a MACD line (the difference between two moving averages) and a signal line (a moving average of the MACD line). Crossovers of the MACD line above the signal line can be considered bullish signals for buying, while crossovers below the signal line can be considered bearish signals for selling.
Average Directional Index (ADX)
The ADX is used to measure the strength of a trend rather than its direction. A high ADX reading suggests a strong trend, while a low ADX reading indicates a weak or non-existent trend. Momentum investors may look for assets with high ADX readings to confirm the presence of a strong trend before entering trades.
These are just a few examples of technical indicators that can be used in momentum strategies. It’s important to note that no single indicator is foolproof, and it’s often beneficial to use multiple indicators or combine them with other forms of analysis to increase the effectiveness of momentum strategies. Additionally, it’s crucial to understand the limitations and risks associated with each indicator and to adapt their usage to specific market conditions and investment goals.
It’s important to note that momentum strategies, like any investment strategy, have their own set of risks. One key risk is the potential for reversals or sudden shifts in market sentiment that can cause previously strong-performing assets to suddenly underperform. Additionally, transaction costs and market liquidity can impact the implementation of a momentum strategy.