Unlocking the Power of Momentum Trading: From Basics to Strategies
What is Momentum Trading?
Momentum trading is a strategy that involves purchasing stocks or other trading assets that have shown high returns over a specific time frame. The idea is straightforward: securities that have performed well in the past are likely to perform well in the future.
Momentum trading is a well-regarded strategy in the trading community. It’s not just popular; it has strong empirical backing. Studies such as “Value and Momentum Everywhere” by Clifford S. Asness and his team have shown the effectiveness of momentum trading across different asset classes like stocks, bonds, and currencies.
Another pillar in the academic foundation of momentum trading is Gary Antonacci’s “Dual Momentum” approach. This strategy combines relative momentum with absolute momentum to maximize returns while minimizing drawdowns. It takes into account not just the past performance of assets, but also their volatility, offering a more nuanced trading strategy for those looking to optimize their portfolios.
The history of momentum trading traces its roots back to the early days of stock markets, but the method gained scientific credence with the advent of modern financial theories. The Efficient Market Hypothesis, for example, initially challenged the effectiveness of momentum trading by asserting that past information is already incorporated into stock prices. However, empirical evidence has consistently refuted this, proving that momentum can be a significant predictor of future returns.
Why Choose Momentum Trading?
This trading strategy focuses on the age-old mantra of “buy low, sell high,” but with a twist—instead of buying low, you’re buying assets that are already on their way up. This reduces your risk substantially, as you’re not trying to predict the bottom price of a stock; you’re simply riding the wave upwards.
Momentum trading is a wide-ranging discipline with numerous approaches for capturing market gains. Below are five momentum strategies that traders have found reliable.
1. Moving Averages: The Foundation
Moving averages serve as a foundational strategy for momentum trading. By averaging a set number of closing prices over a specific period, they create a flowing line that smooths out price volatility. Types of moving averages include Simple Moving Average (SMA) and Exponential Moving Average (EMA). The EMA gives more weight to recent prices, making it more responsive to price changes. Traders often use two different moving averages and focus on crossovers between a short-term and long-term average as buy or sell signals. This technique is particularly effective for ETFs like SPY, which mimics the S&P 500.
2. Rate of Change (ROC): Measuring Absolute Momentum
Rate of Change (ROC) is an oscillator that gauges absolute momentum by calculating the percentage difference between the current price and the price a specific number of periods ago. A rising ROC indicates increasing bullish momentum, making it an opportune time to buy, whereas a falling ROC suggests the opposite. The ROC can be effective when trying to identify the rapidity at which a security’s price is changing, thereby enabling traders to capture emerging trends early on.
3. Comparative Relative Strength (CRS): Ranking Assets
CRS takes momentum trading a step further by comparing the performance of individual assets to a broader market index like the S&P 500. This method is vital for isolating assets that outperform or underperform the market, offering traders a more targeted approach. CRS can be particularly effective when applied within specific sectors, allowing traders to sift through and select the most robust performers while eliminating the weak ones.
4. Dual Momentum: A Hybrid Approach
Dual Momentum, developed by Gary Antonacci, combines both absolute and relative momentum. Absolute momentum is evaluated by comparing an asset’s current performance against a risk-free asset, such as Treasury bonds. Relative momentum, on the other hand, involves comparing different assets against each other. By fusing these two methods, Dual Momentum aims to achieve higher returns with lower risk. Antonacci’s research shows that this strategy outperforms more static asset allocation models.
5. CAN SLIM: A Multi-Faceted Approach
CAN SLIM takes momentum trading beyond just price movement by integrating other indicators into the strategy. Created by William J. O’Neil, the acronym stands for seven key criteria: Current Quarterly Earnings, Annual Earnings, New Products or Services, Supply and Demand, Leader or Laggard, Institutional Sponsorship, and Market Direction. By combining both technical and fundamental factors, CAN SLIM aims to identify stocks that are not only showing strong momentum but are also fundamentally sound, increasing the likelihood of sustained gains.
Many great traders have come from the CAN SLIM world including Mark Minervini, David Ryan, and many others. If you can get a copy of “The Best” published by us over 20 years ago, you’ll read interviews from many of the original legendary traders that apply CAN SLIM.
Dual Momentum Strategy Ideas
These are examples of ways traders potentially use Dual Momentum. Markets are always changing but this will give you a place to start as you develop your own momentum strategies. It was developed by renowned analyst Gary Antonacci who has demonstrated powerful applications of the methodology. These include:
1. Stock vs. Bond Allocation:
- Relative Momentum: Compare the 6-month returns of a stock index like the S&P 500 against a bond index like the Barclays U.S. Aggregate Bond Index.
- Absolute Momentum: Check if the 6-month return of the better-performing index is above zero.
- Action: If stocks outperform bonds and the 6-month return of stocks is positive, allocate more to stocks. If not, move to bonds or cash.
2. Sector Rotation:
- Relative Momentum: Compare the 3-month returns of different sectors like Technology, Health Care, and Consumer Discretionary.
- Absolute Momentum: Make sure the top-performing sector also has a positive 3-month return.
- Action: Invest in the sector ETF with the highest positive momentum.
3. Global Asset Allocation:
- Relative Momentum: Compare the 6-month returns of global equity indices (e.g., U.S., Europe, Emerging Markets).
- Absolute Momentum: Ensure the top-performing index has a positive 6-month return.
- Action: Invest in the region with the strongest positive momentum.
4. Cryptocurrency and Stocks:
- Relative Momentum: Compare the 1-month returns of a cryptocurrency like Bitcoin against a stock index like the S&P 500.
- Absolute Momentum: Make sure the asset with higher momentum has a positive 1-month return.
- Action: Invest in the asset class with stronger and positive momentum.
5. Small vs. Large Caps:
- Relative Momentum: Compare the 3-month returns of a small-cap index like the Russell 2000 against a large-cap index like the S&P 500.
- Absolute Momentum: Check if the better-performing index has a 3-month return above zero.
- Action: Invest in the size category (small-cap or large-cap) with the strongest positive momentum.
6. Dual Momentum with Trend Following:
- Relative Momentum: Use a 50-day moving average to find which asset between stocks and bonds is currently stronger.
- Absolute Momentum: Use a 200-day moving average to confirm if the stronger asset is in an overall uptrend.
- Action: If both conditions are met, invest in that asset.
If you’re interested in digging deeper into Dual Momentum, a seminal paper worth reading is Gary Antonacci’s “Risk Premia Harvesting Through Dual Momentum.” This paper delves into the intricacies of combining relative and absolute momentum for asset selection and offers empirical evidence to support the strategy’s efficacy.
Risk Management: The Linchpin of Successful Trading
In trading, the goal is to maximize gains while minimizing losses. Effective risk management techniques are your safety net. Consider using stop-loss orders to protect capital and diversify so that only a small portion of your capital is at risk on any individual trade.
Momentum trading has stood the test of time and scrutiny, offering traders a robust and statistically sound strategy for generating profits. As you master the indicators, hone your risk management skills, and perfect your timing, you’re not just following a trend; you’re setting yourself up for consistent trading success.
Test Your Mastery: Unlocking the Power of Momentum Trading
Question 1: What is the core idea behind momentum trading?
Question 2: What is Comparative Relative Strength (CRS) used for?
Question 3: What do dual momentum strategies combine?
Question 4: What does Rate of Change (ROC) measure?
Question 5: What is the first element in the CAN SLIM acronym?
For Beginner Level Traders:
“How to Make Money in Stocks” by William O’Neil
- Description: This book introduces the CAN SLIM investment strategy. It aims to teach individual investors how to identify high-growth stocks before they make big price gains
For Intermediate Level Traders:
For Advanced Traders:
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