Momentum Investing | An Introductory Guide | Stock Investor (2024)

“Buy low, sell high” is a common refrain in investing but not the only way to profit.

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The old Wall Street adage has informed the trades of both amateur and experienced investors for decades. While it captures the goal of most investors — that is, to buy things increasing in value to turn a profit — “buy low, sell high” is far from the only way to achieve that.

In the last several years, the dominance of institutional investing and algorithmic trading have made a different strategy more popular than ever. Momentum investing is the practice of buying securities that are already rising in price and selling securities dropping in price. That is to say, investors buy things with upward momentum and sell things with downward momentum.

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“Buy high, sell higher” encapsulates the sentiment behind momentum investing, where investors expect equities to continue on their current trajectory and make consistent, marginal profit.

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Momentum Investing Wasn’t Popularized Until 2004

The origins of momentum investing and who first cemented the strategy are blurry. But, in 1993, researchers published a paper in the Journal of Finance noting that if investors purchased stock in past winners and sold past losers between 1965 and 1989, they would have made considerable abnormal returns.

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Retail investors gradually implemented this strategy in the years following, but momentum investing wasn’t widely used by institutional investors until 2004, when fund manager Richard Driehaus released a statement endorsing the strategy.

“I believe that more money can be made buying high and selling at even higher prices,” Driehaus said. “I try to buy stocks that have already made good price moves, that are often making new highs and that have positive relative strength.”

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Momentum Investing is Driven by Three Types of Momentum

Momentum investing relies on equities continuing their current trajectory. Investors employing the strategy are then looking for stocks that are likely to continue their current growth pattern, rather than buying undervalued stocks and waiting for the market to re-evaluate them.

This momentum can be caused by any one of three phenomena:

Overreaction is when stocks drift away from their intrinsic value, and can be either positive or negative. Investor sentiment may grow excessively optimistic or pessimistic about a stock based upon a news release or earnings event — this excitement drives purchasing behavior and can lead to a stock moving in the “correct” direction, but more than it should were investors perfectly rational decision makers.

Overreaction is also reflective of investors’ willingness to chase top stocks and those endorsed in the mass media. These kinds of herding behaviors cause equities to receive more attention than usual and, in turn, see their prices move further than what is mathematically reasonable.

Momentum of this type was observed en masse in early 2021 with the news surrounding GameStop (NYSE:GME). Retail investors purchased heavily shorted companies because “everyone else is doing it,” driving the companies’ stock prices unnaturally high.

Underreaction is precisely the opposite. Where overreaction causes stocks to move further than they should, underreaction means equities are still moving in the correct direction, but at a slower pace than anticipated.

Underreaction may generate momentum in the idea that stocks will continue to move closer to their intrinsic value as more investors realize the ramifications of an earnings announcement or market event. Thus, an equity may move based on a given news event, but it would make mathematical sense for the stock to move further. Investors then expect the stock to continue in the same direction towards its deserved value, creating either positive or negative momentum.

This kind of momentum can be seen largely in investor stubbornness, and is most commonly a refusal to sell losers to avoid admitting mistakes and overexcitement to sell winners — “quit while you’re ahead” — and demonstrate success.

Reflexivity is the third cause of momentum, and has less to do with investor behavior than overreaction and underreaction. Reflexivity is caused by the positive or negative consequences of a price movement affecting the company’s financial decisions. It goes something like this:

A company’s stock value increases due to some arbitrary event. The increase in value allows the company to raise additional capital and use the money to hire new employees, acquire smaller companies and invest in profitable projects. The success of these decisions leads the company to make additional profit and thereby drive the stock price higher still.

This reflexivity scenario works the other way around, too. A company experiencing a sudden dip in stock price may be forced to sell assets or fire key workers, causing the company itself to become less profitable and thereby driving the stock price further down.

Reflexivity is often a product of how effectively a company can capitalize on opportunities via reinvestment, and how controlled their response is to financial hardships. It, then, is more based on mathematical trends and company management than investor behavior and expected irrationality.

Momentum Investing Tracks Equities Over a Given Period of Time

At the simplest level, tracking momentum is simple. Investors select a given period of time — everywhere from a 12-month period to a few seconds — and compare how a company has performed in that period of time to various benchmarks.

Retail investors and fund managers may use momentum investing for longer holds, analyzing a company’s recent returns and anticipating they continue in the same direction over the next few months. With institutional investors becoming more based in algorithmic trading, however, it is now commonplace for a program to purchase equities with positive momentum over the last five seconds and sell two seconds later.

While programs can track technical metrics in real-time and automate their decisions based on momentum, using momentum investing as a human can take a considerable amount more effort.

Where value investors can analyze a company and set a target price, then wait and see if the market acts according to their desired outcomes, momentum investors are forced to analyze and reanalyze the appropriate technical metrics on a regular basis. The short-term nature of momentum investing can make it highly profitable but also require greater effort than other investment strategies.

Momentum Investing Uses a Variety of Technical Metrics to Predict Future Performance

Investors have options when it comes to the technical indicators they use to track momentum. At the surface, we can look at the stock, see if it has gone up or down, and buy or sell accordingly. This simple strategy of buying winners and selling losers works well in the long term.

With that strategy in mind, there is plenty of freedom to get more granular when searching for desirable equities with momentum. The first and most widely used indicator is called the relative strength index. The relative strength index (RSI) compares the magnitude of recent gains and losses over a preselected period of time to determine whether an asset is overbought or oversold.

An equity is generally considered to be overbought (thereby having excessive positive momentum) when the RSI approaches 70. An equity can be called oversold (showing excessive negative momentum) when the RSI nears 30.

Relative strength index is useful for predicting when equities’ momentum will change direction. The further past 70 a stock’s RSI goes, the better a candidate for a price pullback it becomes, meaning its momentum will have peaked. Similar logic applies to those stocks with RSI below 30, indicating that the stock’s downward momentum may soon be coming to a close.

Charted below is the relative strength index for the trailing 30 days of Johnson & Johnson (NYSE:JNJ). Johnson & Johnson currently has an RSI near 60, suggesting the stock still has positive momentum but is gradually becoming more overbought.

Chart provided by StockRover, start your free trial here.

RSI can be useful when predicting how long a stock’s momentum will continue, but more so when evaluating how much of a recent change in share price can be attributed to market overreaction. As such, it is a useful tool in any momentum investor’s toolbelt.

Also used by savvy momentum investors is the money flow index. The money flow index (MFI) works in a fashion similar to RSI and is interpreted the same, but MFI pays less attention to the magnitude of recent gains and losses and more to the relationship between changes in price and volume.

Changes in levels of volume can help indicate the conviction of a current trend, with higher numbers meaning the stock is likely overbought and lower numbers meaning it is oversold. Numbers closer to the midrange of the chart may mean the current momentum is likely to continue.

Charted below is Johnson & Johnson with a MFI calculated over the last 30 days. The number currently sits at 64.05 and rising, meaning it is plausible for the current trend to continue, but the stock’s momentum may soon run out if it becomes too overbought.

Chart created using Stock Rover.

And for completion, here is the 30-day volume of JNJ correlated to the MFI chart shown above.

Chart provided by StockRover, start your free trial here.

For a complete picture of JNJ or any other company’s momentum, it is useful to look at all of the relative strength index, money flow index and volume together, as well as any other momentum indicators appropriate to your investing needs.

These momentum indicators and several others can be charted on a variety of websites, but we recommend Stock Rover. The program allows investors to analyze and chart over 600 unique metrics and offers explanations for nearly all of them — in turn, the rigor and detail of Stock Rover make it a powerful tool for investors both new to and experienced with momentum investing.

Many ETFs Employ Momentum Strategies as Their Primary Selection Criteria

Investors interested in momentum investing conceptually but not wanting to invest the time in charting and repeatedly reanalyzing stocks may still reap the benefits via exchange-traded funds (ETFs). Listed below are some of the top ETFs that utilize momentum investing as their primary investment strategy.

Momentum Investing is a Powerful Strategy That Can Lead to High Short-Term Gains

Although the technical details of momentum investing can be hard to digest and harder still to implement, the strategy itself is a reliable mode of investing that allows many to beat the market. “Buy high, sell higher” is exactly what has led all of retail, institutional and algorithmic investors to reap the benefits of momentum and make a lot of money in the process.

Jonathan Wolfgram is an editorial staffer who writes website content at Eagle Financial Publications. He graduated from the University of Minnesota with Bachelor’s degrees in Finance and Philosophy. Jonathan writes forwww.DividendInvestor.comandwww.StockInvestor.com.