The fundamental idea underlying momentum investing is to focus on assets that have demonstrated strong recent performance. This approach capitalizes on market trends, which are often driven by investor psychology or market inefficiencies.
But we believe you can move beyond this basic approach and consider more advanced insights to make the strategy even more effective.
There are some key indicators that can be of value to momentum investors, and learning how to help manage risk and leverage tools available in the market can also be significantly beneficial.
Let’s discuss how you can refine your approach to momentum investing, avoid some of the most common mistakes, and develop a disciplined investment plan.
Technical indicators aren’t the sole provenance of professionals—retail investors can access a broader toolkit of technical indicators to help analyze price movements and trading volume too.
Two of the most popular and effective indicators used in momentum investing are the Relative Strength Index (RSI) and the Moving Average Convergence Divergence (MACD).
The RSI is a momentum oscillator that measures the speed and change of price movements.1 It moves between zero and 100 and can help identify overbought or oversold conditions.
How it works: An asset is generally considered overbought when the RSI is above 70 and oversold when it is below 30. For a momentum investor, an RSI reading climbing towards 70 can confirm potential strong upward momentum. However, a reading above 70 could signal that the trend is becoming overextended and might be due for a pullback.
Practical application: Instead of just buying a stock when the price is rising, you might use the RSI to time your entry. For example, you could look for a stock with a confirmed upward trend that has temporarily pulled back, with its RSI dipping near the 50 level before hopefully starting to rise again. This may offer a better entry point than buying at the peak.
Most online brokerage and charting platforms will allow you to add technical indicators such as RSI to a stock’s chart. Once it has been added, the RSI will appear as a line graph below the main price chart.
The MACD is a trend-following momentum indicator that shows the relationship between two moving averages of a stock’s price.2 It consists of the MACD line, a signal line, and a histogram.
How it works: When the MACD line crosses above the signal line, it is a bullish signal, suggesting that upward momentum may be increasing. Conversely, when the MACD line crosses below the signal line, it is a bearish signal, indicating that momentum may be waning.
Practical application: A momentum investor can use a bullish MACD crossover as a confirmation signal to enter a trade. For instance, if a stock is already in an uptrend, a fresh MACD crossover may reinforce your decision to buy. The histogram, which represents the distance between the MACD and signal lines, can also show the potential strength of the momentum. (A growing histogram signifies strengthening momentum.)
Just like RSI, most online brokerages make the MACD available through their charting tools.
All investing involves risk and may lose money. Momentum investing's focus on stocks that are rising rapidly comes with some inherent risks. Trends can reverse suddenly and unexpectedly, turning profits into losses.
Without a robust plant to manage risk, an investor could be exposed to significant drawdowns. For retail investors, disciplined risk management is essential to long-term success.
A stop-loss order is an instruction applied to your account to sell an asset when it reaches a certain price. This is the primary defense against a sharp reversal. Before putting in any trade, determine the maximum loss you are willing to accept.
A common approach is to set a stop-loss that is five to eight percent below the stock’s purchase price. Alternatively, an investor might choose a trailing stop-loss, which moves up as the stock price rises but remains fixed if the price falls. This makes it possible to lock in profits while allowing the stock scope to appreciate.
Never put all your eggs in one basket. An appropriate position size ensures that a single losing trade won’t wipe out a significant portion of your portfolio. A general rule of thumb is to risk no more than 1–2% of total portfolio value on a single trade.
For example, if you have a $20,000 portfolio and decide to risk 1% per trade, your maximum loss on any single position should be $200. This calculation helps determine how many shares to buy based on the stop-loss level.
While momentum investing may involve concentrating on a few strong performers, that doesn’t mean you should disregard diversification. Instead of focusing on one stock, consider building a small portfolio of 5–10 stocks across different sectors that are all exhibiting strong momentum. This can help mitigate the impact if one sector takes a turn south.
Many momentum investors make predictable mistakes. It’s vital to be aware of these common pitfalls so you can avoid them.
Overtrading: The unrelenting search for the next big winner can lead investors into frequent buying and selling. Too much trading not only racks up transaction fees but can send you down the primrose path of emotional decision-making. Stay disciplined and avoid the temptation to chase every small price movement.
Ignoring market conditions: Momentum strategies perform best in trending, bullish markets. During choppy, sideways markets or sudden downturns, momentum can struggle. It is critical to be aware of the overall market trend. If the broader market is trending downward, it may be wise to trim your exposure or temporarily pause your momentum strategy.
Momentum investing thrives on the dynamics of investor psychology. By understanding the psychological biases that drive market participants, it’s possible to better anticipate and capitalize on momentum trends.
Herding occurs when investors collectively pile into trends, pushing prices upward (or downward). Momentum investors can benefit from this tendency by identifying and riding the waves created by widespread sentiment.
Many investors overestimate their ability to predict markets, causing them to hold onto losing investments or delay moving into winners. Momentum strategies may sidestep this obstacle by relying on data-driven decisions rather than subjective judgment.
When markets hit record highs, the fear of missing out often triggers surges in buying activity. Momentum investors can profit by detecting these patterns early and deploying funds as trends gain traction.
By being aware of these behavioral factors, investors can potentially position themselves to benefit from the irrational decisions of others instead of falling victim to them.
In the past, momentum investing was largely the bailiwick of institutional investors with access to sophisticated tools. Today, technology has leveled the playing field. Retail investors can now use a variety of platforms and tools to implement momentum strategies effectively.
Stock screeners: Most online brokerage platforms offer powerful stock screening tools. You can set up custom screens to find stocks that meet your specific momentum criteria, such as "price above the 50-day moving average" or "six-month performance in the top 10 percent."
Charting platforms: Websites like TradingView or the charting tools within your brokerage account allow you to apply technical indicators like RSI and MACD with ease. Visualizing price action and momentum can help you make better decisions.
Automated alerts: Set up price and indicator alerts to notify of potential entry or exit points. This avoids the necessity of incessantly watching the market, and helps you execute your plan with discipline.
Momentum investing can be a rewarding strategy for the disciplined investor. It offers a dynamic way to take advantage of the market's most pronounced trends. While it requires a more active approach than buy-and-hold investing, the principles are accessible to any dedicated investor.
It’s always a good idea to get a feel for the strategy by paper trading; you’ll develop your skills without risking real money. Use a stock screener to identify some potential candidates and track their performance. Practice using indicators like the RSI and MACD to identify entry and exit points.
Once you feel confident, start out small. Most importantly, always prioritize risk management: The key to surviving market reversals and working toward long-term success.