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An Introduction to Momentum Stocks

Jul 18, 2008
The strategy of trading momentum stocks may not be the most popular method around, but it's been proven effective. If you're willing to pick stocks based on a given set of parameters and have a good sense of timing related to the markets, momentum stocks are something you should look into.

What it are momentum stocks?

Momentum investing is the most difficult to define of all the common trading strategies, but simply put, it's based on looking for companies whose stocks have been getting stronger over the past 3 months to a year. The rule here is "buy high, sell higher."

Why people choose momentum investing

Investing in momentum stocks is simply a proven-effective strategy. The two people credited with defining momentum investing, Narasimhan Jegadeesh and Sheridan Titman, showed this strategy yields average returns of 1% per month for the 3 to12 months following a given trigger event that signals when to buy the stock. Their first report was published in 1993 by the American Finance Association and another report that confirmed their earlier research was published in the Journal of Finance

The benefits of trading momentum stocks

The first is profitability. Statistics show trading momentum stocks is a sound and profitable strategy provided you do your research and watch your timing.

Another advantage for some is that the system doesn't require absolute accuracy when picking stocks. Instead, momentum investors look for large reward to risk ratios. For each stock that loses a small amount, they find at least one if not several that brings in a 50% or higher profit.

Relative simplicity is another benefit of this strategy. Most trading systems require an enormous amount of self-discipline, which many people just don't have. The system of trading momentum stocks is based completely on concrete data that's easy to find, so your emotions won't take you off course.

Although many people presume the turnover in this strategy would be extremely high, but in most cases it really isn't particularly bad. Average turnover seems to be around 90% and while high, it's still lower than with certain other strategies.

The downsides of trading momentum stocks

Momentum investors don't buy stocks to hold. The stocks they buy are highly volatile and while the investors expect their momentum stocks to do well in the short term, they're ready to sell as soon as the stock starts going downhill. That means if you don't get your timing right, you won't profit much.

Another complaint against the momentum trading is that economists can't seem to figure out exactly how this strategy works, which makes it seem like it's based on nothing but dumb luck. Some economists believe it works because the high returns offset the risk, while others think it's a case of smart investors taking advantage of the mistakes of other investors, such as overreaction to hot stocks.

Trading momentum stocks is a sound strategy that, while riskier than some, can provide excellent returns for those who know how to identify momentum stock accurately and can get their timing right.
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