Last Updated on 14 June, 2021 by Samuelsson
Whether it is “buy low and sell high” or “buy high and sell higher”, all an investor wants is to get the best returns possible. While the former has been a long-standing trading adage, systematic momentum strategies apply the latter, which effectively requires the investor to sell losers and buy winners. You may be wondering: what are systematic momentum strategies?
Systematic momentum strategies are rule-based investing methods that seek to benefit from buying stocks that are going up, selling them as soon as they show signs of going down, and moving the capital to other stocks that are starting to jump higher. In essence, they are trading strategies that are centered on tracking the momentum of various stocks in the market and buying only the top-performing ones.
In this article, we will focus on how you can benefit from using systematic momentum strategies. We will highlight the different momentum tools, how to combine them to formulate profitable trading strategies, the steps to implement a systematic trading strategy, advantages and disadvantages of using the systematic momentum strategies.
What does momentum mean in stocks?
The term momentum is mostly associated with physics. It simply refers to the state of motion an object possesses, which tends to depend on the weight of the object and how fast it is moving. And according to Newton’s first law of motion, an object in motion doesn’t change momentum until it is acted on by an external force. But the greater the momentum, the longer it will stay in motion because it will take time to bring it to a halt.
Applying the motion and momentum analogy to the financial markets, momentum can be defined as the speed at which the price of security changes. This entails the movement of a security’s price in a particular trend. Momentum can either be in an upward or downward trend. While increased buying of security can drive its momentum upward, increased selling of security can drive momentum downward.
Momentum can also be absolute or relative. Absolute momentum refers to the momentum unique to a particular individual security. This implies that we are looking at the asset’s trend without reference to any other thing. When we look at the momentum of Apple (NASDAQ: APPL), for example, without comparison to any stock or index, that is its absolute momentum.
On the other hand, relative momentum entails comparing the momentum of one security to that of another or an index. For example, when you compare the momentum of APPL to Facebook (NASDAQ: FB) or the S&P 500 Index, you are referring to relative momentum.
With these in mind, you may ask: what is momentum strategy? Well, we can say that momentum trading is simply about ranking the momentum of securities and buying only the securities that have the best relative momentum and selling them immediately they drop in the rank and use the money to buy the new top performers.
In terms of classical technical analysis, we can say that it is about buying stocks in the strongest uptrends and selling them once they stop trending strongly so that you can reinvest the money in other stocks that are breaking out into strong trends. A trend in this sense means the direction in which stock prices are headed — when asset prices are going up, technical analysts refer to this as a bullish trend, and when asset prices are going down, they refer to this as a bearish trend. Now, you may ask: what is a systematic trend, and do momentum strategies work? We will get to that in a moment.
What are systematic momentum strategies, and how do they work?
Systematic momentum strategies are momentum-based that are implemented according to a predetermined set of rules, which may be automated or executed manually. The key point is that the momentum strategies are systematically implemented based on a set of rules — it doesn’t matter if the execution is automated, semi-automated, or manually.
In essence, it is a systematic momentum strategy if it is rule-based and seeks to benefit from buying stocks that are going up while selling those stocks as soon as they show signs of going down and moving the money to other stocks that are starting to trend strongly. Systematic momentum strategies are centered on tracking the momentum of various stocks in the market and buying only the top-performing ones.
They are a set of strategies traders use to measure the momentum of various securities so they can select the best ones to trade. This is in line with the popular saying among trading circles, “the trend is your friend”, which implies that stocks with strong momentum are more likely to keep going higher than the ones that are trading at a value, so you stand a higher chance of making money by buying stocks that are breaking new highs.
While this approach seems to contradict the trading adage, “buy low and sell high”, it has been proven to work. Moreover, trading against the market’s momentum is comparable to standing in the path of a moving train and expecting the train to turn around at that point. Common sense shows that it’s better to ride in the direction of the train.
Systematic momentum trading, therefore, is a rule-based way of profiting from the direction of the market’s volatility by using various indicators that detect momentum. In this sense, momentum can be likened to ocean waves, while the trader can be likened to a surfer who rides the crest of the waves, jumping from one crest to another before the first one dies out. However, in the case of the systematic momentum trader, he uses a specific guide (system) to know when the wave is building or crashing so that he can take the appropriate position.
Obviously, the trader would need some tools to create his trading system. So, what are those tools the trader needs to identify and rank stocks with the greatest relative momentum?
Some of the momentum trading indicators available to traders
To measure the momentum of the securities they want to trade, traders make use of a type of technical indicators called momentum indicators. A momentum strategy indicator is a tool that can help a trader gain insight into how rapidly an asset’s price moves in a given direction and whether it is likely to continue on the same trajectory. The most commonly used momentum trading indicator is the rate of change (ROC) and the moving averages. While there are many others, let’s take a look at five common ones that can be used in creating systematic momentum strategies:
- Moving Averages (MAs): A moving average is a technical indicator that helps traders determine the trend direction for any asset. It is calculated by adding up all the data points over a chosen period and dividing the sum by the number of periods. Moving averages track the price movements of a security in comparison to its average price over a particular timeframe. Traders use moving averages to measure momentum by checking how fast the price is progressing from the moving average, but in some cases, they may use two moving averages and use the difference in the movement of the two averages to measure the momentum of the asset. However, some traders believe that moving averages are lagging indicators in the sense that the signal would not show on the chart until after the momentum has occurred.
- Rate of change: Sometimes called The Momentum Indicator among Forex traders, ROC measures the rate at which a security’s price changes over a given period. It is often expressed as the percentage change in the current price compared to a certain period in the past. It is calculated by dividing the current price by the price of at a specific period in the past and then multiplying the quotient by 100. So, it gives a percentage rate of change. Traders commonly use this indicator to measure the absolute momentum of stocks and to compare the momentum of stocks to an index to get the relative momentum, which they now rank from top to bottom.
- Stochastic: The Stochastic indicator also gives traders information about momentum. It indicates how fast or strong an asset price moves by evaluating the closing price of a security compared to its price within a given period. Stochastic also show whether an asset is overbought or oversold through a range of values (0 to 100). If the asset is deemed overbought (80 and above), it might indicate an impending correction. On the other hand, if an asset is deemed oversold (20 and below), it might indicate the end of a price correction.
- Relative strength index (RSI): The RSI measures the strength of recent price action and the speed at which they change. With a scale of 0 to 100, it also shows whether the security is currently overbought or oversold. If the indicator is below 30, it indicates the stock is oversold which is a potential buy signal for the trader. This attracts buyers to the market, which in turn can fuel the momentum. If it’s above 70, it is deemed overbought, which might indicate a potential price correction.
- Moving average convergence divergence (MACD): Moving average convergence divergence (MACD) is a momentum indicator that shows the relationship between two moving averages of an asset’s price. The MACD is calculated by subtracting the 26-period exponential moving average (EMA) from the 12-period EMA. The result of that calculation is the MACD line. A nine-day SMA of the MACD called the “signal line,” is then plotted above the MACD line. The indicator rising above the 0.0 level is an indication of rising momentum while falling below that level is considered a sign of falling momentum. Some traders prefer to use MACD to measure momentum.
- Breaking/making new highs: Some price action traders don’t like using indicators for anything; instead, they find ways of using price action to achieve whatever they intend to do. These traders look for stocks that are making a certain period high (for example, a 4-week high) and adjudge those to have the best momentum at that moment. While this approach may not be easily measurable, it still serves them their purpose.
Implementing systematic trading with momentum: how do you use momentum strategy?
Whatever the strategy you are using, systematic trading makes things a lot easier. By systematic trading, we mean having a set of rules that govern what assets to buy, when to buy them, and when to exit. With those rules, you may decide to automate the strategy, but if you want, you can still execute them manually.
Generally, to implement a systematic momentum strategy, here are the steps to follow:
Step 1: Select a timeframe
When trading a momentum strategy, it is best to choose a timeframe you operate with, as this would determine the period you set your momentum strategy indicator and how often you would get trading signals, which in turn, determines how often you are active in the market.
However, your trading style determines the timeframe you choose. If you are a swing trader, a weekly or 2-weekly timeframe may do, but if you are a long-term position trader or investor, you may have to choose a monthly or 3-monthly measure. Some investors even choose a 12-monthly measure of momentum.
Step 2: Choose a specific measure of momentum
You need to choose how to measure the momentum of securities you intend to trade. It can be any of the momentum indicators we discussed earlier. The most common ones used by traders are the ROC and moving averages, but you can also use the RSI, stochastic, MACD to do the job, or even price action moves like breaking new highs. The most important thing is that the indicator you use can measure both absolute momentum and relative momentum so that you can rank the securities you are monitoring.
Step 3: Measure the relative momentum with reference to the relevant index
Use whatever momentum indicator of choice to measure the momentum of the securities you want to trade. The key is to measure the momentum relative to a common reference point, which is normally a broad market index. You can use the S&P 500 Index as your reference point for measuring relative momentum, but if you are only considering tech stocks, it may be fin to use the Nasdaq 100 Index or the Nasdaq Composite.
Step 4: Rank assets according to momentum
When you measured the relative momentum of the stocks you are screening, it’s time to rank them from top to bottom so you can identify the fast movers and slow laggards. The stock that has the highest rate of change over the timeframe you have chosen gets ranked number one, while the one with the lowest momentum gets ranked the least number. The idea is for you to buy only the top-performing ones.
Step 5: Adjust for volatility and liquidity
It pays to keep an eye on volatility. While positive volatility can be a good thing for momentum trading, negative volatility is not. By negative volatility, we mean the likelihood of dropping quickly because of a lack of liquidity. Make sure you choose only stocks that trade X million shares per day on average. That way, it will be easier for you to unload your position when it is time to exit.
Step 6: Check for broader market trends
As they always say, a rising tide lifts all boats and a falling tide tends to drop all boats. This is an incredibly important consideration to keep in mind when trading the momentum strategy. What this means is that you make use of this strategy when the entire market is in a bull trend — a bull market. During a bear market, such as the 2001/2002 bear market or the great recession of 2008-2009, it is best to stay out of the market. One easy way to go about this is to include in your set of rules this simple rule: trade only when the S&P 500 Index is above its 10-month SMA and stay away from the market when the S&P 500 is below its 10-month SMA.
Step 7: Keep monitoring the momentum
Even when everything is in order — it’s a bull market and all the rest — and your rule is to buy the top five performing stocks, you have to keep monitoring the momentum and ranking of the stocks in your universe of stocks. Once the momentum in the stocks you bought drops and they fall below in ranking, you sell them and reinvest the money in the new top-ranking stocks.
Merits and demerits of systematic momentum strategies
There are many advantages and disadvantages associated with trading with systematic momentum strategies.
Trading with systematic momentum strategies has certain benefits, such as the following:
- Potential for high profit over a short period: The essence of systematic momentum trading is to make superior returns. By choosing stocks that have strong momentum, you stand a chance to potentially make huge gains over a short duration. For example, shares of Tesla appreciated by over 700% in 2020.
- Benefit from market volatility: Trading with systematic momentum strategies enables traders to benefit from the right kind of volatility. Many traders stay away from volatile securities because of the risks involved. However, with the right liquidity, securities with positive volatility are perfect hunting grounds for systematic momentum traders because they can benefit from asset mispricing and the knee-jerk reactions of less informed traders.
- Profit from the emotional decisions of other traders: Herd mentality can push the buying or selling pressure of an asset especially in this age of social media and meme stocks. Systematic momentum traders can profit from the emotions of other traders catching the trend early and taking positions appropriately. All they have to do is pick your asset and wait for the herd to stampede the price upwards due to fear of missing out (FOMO).
- Keeps you invested in the strongest markets or most active sectors: Trading with momentum means that you are tracking sectors of the market that have the highest trading volumes and liquidity. This means that you are in the most active sectors and strongest markets which offer opportunities for profit because you can enter and exit positions quickly. Also, the bid-ask spread of sectors with high trading volumes are usually thinner which means that your transaction costs are lower. This is in contrast to weak sectors with low trading volumes, which tend to incur higher trading costs due to illiquidity and a wider bid-ask spread.
Despite the benefits, there are certain demerits associated with systematic momentum trading strategies, and they include:
- It can be time-consuming: Being a successful systematic momentum trader requires spending long periods monitoring the market and tracking the momentum of stocks in your universe. Depending on your timeframe, this might mean checking on things every day. However, you can reduce the stress by automating your system such that the computer scans the market, measures the momentum of the stocks, ranks them, and takes the trades based on your set rules.
- Higher risks than passive investing: Active trading often carries a higher risk than passive investing. This is because you are constantly buying and selling, which incurs trading costs that can eat on your capital, but more importantly, you may be over-concentrating your capital to a few stocks, which exposes you to systemic risks. To limit that risk, it may be wise to diversify across many stocks and using a weighting method to allocate more capital to stocks with the highest momentum.
Systematic momentum trading can be highly profitable when properly implemented because the momentum approach has been proven to give superior returns compared to unguarded value hunting. Moreover, by using a rule-based system, you can easily cut losses early, lock in profit, catch trends, and avoid the herd mentality.
Of course, you can implement the strategy manually, but that can be time-consuming and less efficient. It is preferable to get a good programmer to create an algorithm that can automate the process for you once you have created your entire system of selection, entry, and exit rules.