Momentum Trading Strategy

Momentum: Riding the Horse That's Already Running

Momentum trading applies the physics idea of momentum to the market: a stock that's been moving strongly up (or down) recently tends to keep moving in that direction for a while. It's almost the opposite of value investing's "buy low, sell high" — momentum trading is closer to "buy a stock that's already rising, at an even higher price, hoping to sell it at a much higher price still."

💡 This strategy cares less about "why" a stock is rising and more about "how strongly" it's rising right now. Earnings beats, industry trends, buying pressure — the reasons can vary, but a momentum trader treats the strength of the move itself as the trading signal.

Key Indicators for Measuring Momentum

RSI (Relative Strength Index)

A 0–100 indicator that compares the magnitude of gains to losses over a set period (typically 14 days).

RSI = 100 - [100 ÷ (1 + Average gain ÷ Average loss)]

• RSI above 70: Considered "overbought" — often read as "the price has risen a lot in a short time"
• RSI below 30: Considered "oversold"
• RSI near 50: Buying and selling pressure roughly balanced

⚠️ In a momentum strategy, RSI above 70 isn't necessarily read as "about to fall" — it's often read instead as a sign the current trend is very strong. In genuinely strong uptrends, RSI staying above 70 for extended periods is common. How you interpret RSI really depends on which strategy's lens you're using.

Volume Surge

A noticeable jump in trading volume compared to normal, signaling that a lot of market participants are actively interested in and trading that stock. A price increase accompanied by a volume surge is read as more credible; a price increase without volume is treated with suspicion as a "weak move."

Relative Strength (vs. sector or market)

Comparing an individual stock's return to its sector index or the broader market. If the market falls 1% on a given day and a stock rises 3%, that stock shows very strong relative strength versus the market. Momentum traders prioritize these "stocks beating the market."

A Basic Trading Rule Example

1. Screen for stocks with strong returns over a recent period (e.g., the last 3 months).
2. From those, narrow down to stocks trading near new highs with a clear surge in volume.
3. Enter in stages during pullbacks (temporary dips within the broader move).
4. Exit when momentum shows signs of fading (declining volume, weakening relative strength, breaking below a key moving average).

Risks of Momentum Trading

⚠️ The moment momentum breaks is the most dangerous part. Stocks that rose the hardest often pull back the hardest too ("the higher it climbs, the faster it can fall"). This is a strategy where following your stop discipline matters even more than chasing the target.

Other notable risks:

• Chasing in late: By the time a stock gets talked about as "hot" in the news or on social media, the early part of the move has often already passed.
• Crowded trades: If many traders spot the same momentum signal and pile in together, even minor bad news can trigger a wave of coordinated selling.
• Fakeouts: A stock that barely breaks a new high before immediately reversing can trigger a wave of stop-outs among late momentum entrants, accelerating the decline.

Momentum vs. Moving Average Crossover: What's the Difference

The moving average crossover strategy from the previous lesson is about confirming — belatedly — that a trend has reversed direction, and following it. Momentum trading is about riding the sheer strength of a move that's already underway. In practice, the two are often combined — for example, confirming direction with a golden cross, then narrowing down to only the stocks within that group showing the strongest relative strength and volume.

Worth Noting: Momentum Is Relatively Well-Validated Academically

Throughout this lesson and Lesson 5 (ICT), you've been reminded repeatedly that certain concepts aren't academically validated. Momentum is a notable exception — it's one of the more broadly validated phenomena in academic finance. Starting with Narasimhan Jegadeesh and Sheridan Titman's 1993 study, researchers have repeatedly observed, across many markets and time periods, that stocks with strong returns over the past 3–12 months tend to keep outperforming the market average for some period afterward. This is what academics call the "momentum factor."

⚠️ That doesn't mean "so it always works." The momentum factor has also been documented to break down sharply during specific periods — particularly sharp market crashes followed by sudden rebounds — a phenomenon known as a "momentum crash." Academic validation and "always safe to use" are two different things.

Sector Rotation and Momentum

Momentum shows up not just in individual stocks but at the sector level too. Capital flowing into specific sectors (semiconductors, financials, healthcare, and so on) and then rotating into different sectors as the economic cycle shifts is called sector rotation. When you're assessing a stock's momentum, also checking whether its sector as a whole is currently attracting capital can raise your confidence in the signal by another notch.

Summary

• Momentum trading is based on the premise that "stocks already moving strongly tend to keep moving in that direction for a while."
• RSI, volume surges, and relative strength versus the market are the key momentum indicators.
• Pullbacks after a strong move tend to be sharp, which is why strict stop discipline is especially important in this strategy.

In the next lesson, we'll cover a strategy built on the opposite philosophy from momentum: mean reversion.