The Complete Guide on Momentum Investing Strategies

Momentum refers to an object’s mass and velocity—the larger an object and the faster it moves, the greater its momentum. Momentum investing adapts this physics principle into a trading strategy that exploits current market trends.

By analyzing chart patterns for stocks with high velocity and price momentum, momentum investors aim to capitalize on bullish trends. Rather than holding long-term positions, momentum strategies focus on short-term trades, riding successful assets to a peak and then selling when a downtrend begins. 

Momentum investing offers an alternative to classic strategies like buy-and-hold or day trading. Using technical analysis to find overbought and oversold positions, you can leverage momentum investing to profit from short-term price movements and directions.

Why invest in momentum?

Most historians credit American investor and businessman Richard Driehaus with popularizing momentum investing in the 1980s and 1990s. Driehaus believed you could make more money buying high and following an uptrend than buying underpriced stocks and hoping for a bearish trend reversal. 

Momentum trading takes advantage of classic investor behaviors. Every investor attempts to “buy low, sell high,” and these behaviors turn into patterns. With practice, you can learn to map these patterns and identify different momentum types and velocities. 

If you’re a day trader, it’s easy to incorporate momentum investing into your current day trading strategy. Even non-day traders can apply momentum trading best practices to an existing portfolio. Although past returns don’t guarantee future success, momentum can help you recognize a trend’s strength so you can plot appropriate entry and exit points. 

How momentum investing works

In 1993, Narasimhan Jegadeesh and Sheridan Titman published a study on the momentum factor, the critical element in momentum investing. The momentum factor is a market anomaly in capital market theory. According to this anomaly, securities that recently rose tend to continue rising over the short term. 

You can find various explanations for how momentum investing works. Most stem from behavioral finance, which examines how emotions, sentiment, and social factors affect investing decisions. These theories claim that momentum investors profit from behavioral traits exhibited by other investors, such as confirmation bias, herd mentality, and overreactions.

To define their entry and exit strategies, momentum investors typically rely on technical indicators such as moving averages (MA), the relative strength index (RSI), and moving average convergence divergence (MACD). Some traders look for MA crossovers, viewing a 50-day MA crossing over a 200-day MA as a buy signal and the opposite as a sell signal. Others track the Treasury yield curve or assess price history to find securities with the most robust momentum.  

5 momentum strategies

Let’s take a look at some common momentum strategies. 

1. Sector momentum

The stock market contains 11 primary sectors, each with unique strengths and weaknesses. Some perform better than others at different times and display varying volatility depending on prevailing economic variables.

One strategy for profiting off each sector’s unique characteristics is Composer’s sector momentum strategy. Once a month, this strategy invests in the three sectors with the best performance over the past 200 days. Investors can use sector momentum to get up-to-date performance data on the stock market’s heaviest hitters, making it a big-picture momentum strategy with a set holding period.

2. Big tech momentum

In the past 20 years, tech has become the fastest-growing sector on the market, with high average price-to-earnings ratios. Our big tech momentum strategy looks at the stock prices for the largest companies in the Nasdaq 100 index. The approach attempts to generate excess returns by using price action as a momentum indicator to identify the best-performing big tech companies.

Every month, this strategy invests in the two big tech stocks with the best performance over the past month. Historical price data of companies like Amazon, Meta, and Apple indicate trends during the monthly rebalancing period.

Although this strategy focuses on the Nasdaq 100’s largest and most liquid stocks, it may generate short-term transaction costs that drag on performance. Backtest this strategy with fee estimates using Composer’s backtesting software to determine whether it deserves an allocation in your portfolio.

3. Commodity momentum

Composer’s commodity momentum strategy aims to recognize the best-performing commodities. It considers performance over the most recent time series and evaluates this data relative to the portfolio’s rules. These rules capture risk factors and market dynamics reflected in commodity prices. 

Whereas investors can invest in commodities through mutual funds, futures contracts, and physical holdings, this strategy focuses solely on commodity ETFs with sufficient trading volume. Some commodity momentum investors leverage the strategy to hedge against inflation. Others use it solely to generate positive returns. 

4. Global momentum

By looking for enduring price trends, our global momentum symphony can spot underreactions and overreactions in the global market, informing you in your investment decisions.

World markets, such as the U.S., Europe, Australasia, the Far East, and Emerging Markets, are all evaluated alongside bonds and commodities. Once a month, this strategy invests in the best-performing asset within each category, providing you with a diversified strategy containing domestic and international equities, bonds, commodities, and alternative investments.

5. The 60/40 portfolio

Composer’s new 60/40 portfolio option provides a novel way to plan your investments. You may know the classic 60/40 portfolio, which contains 60% stocks and 40% bonds. We modernized this idea, updating the strategy to include leverage, an efficient core, and commodities for diversification.

This portfolio allocates two-thirds to a modestly leveraged ETF designed to deliver returns like a traditional 60/40 strategy. This frees up one-third for diversifying assets—in this case, commodities—making it a multi-strategy portfolio that combines 60/40 and commodity momentum. 

Is momentum a sound investment strategy?

Momentum investing works when you can identify price trends and ride bullish securities to higher heights. However, earning consistent returns with the strategy is much more complicated than it sounds. As an active strategy, momentum investing requires you to closely monitor price movements and react quickly to price changes. 

Momentum trading can incur higher transaction costs due to its reliance on short-term trades. This means momentum investors may also face higher short-term capital gains taxes. 

When considering these costs, momentum investing can prove challenging for beginner investors. However, if you take the time to study price movements, learn technical indicator signals, and understand how behavior impacts financial decisions, momentum investing can yield above-average returns. 

Build your own momentum strategy with Composer

Finding the best momentum trading strategy takes time and effort. Composer makes it easy to discover popular momentum strategies or make your own using our no-code strategy builder. Choose from numerous technical indicators (e.g., RSI, standard deviation, and exponential moving average) to create your ideal strategy, backtest your results, and find what works. 

With Composer, you can elevate your momentum investing skills and explore creative ways to buy high and sell higher. Try Composer today and see how momentum investing can help you reach your financial goals.