Quick definition Momentum trading exploits the tendency of price moves to continue. A stock that has risen 10 percent is expected to continue rising. A stock that has fallen 10 percent is expected to continue falling. What it is Momentum strategies buy winners and sell losers. The strategy assumes that strong past returns predict stronger future returns. Momentum trading differs from mean reversion. Mean reversion bets on reversal; momentum bets on continuation. Why it matters Momentum is a well-documented market anomaly. Academic studies show that momentum strategies are profitable historically. Momentum is popular with trend-following funds and CTAs (commodity trading advisors). Mechanism Why does momentum work? Several theories: - Slow information diffusion: news is absorbed gradually, creating trending prices - Positive feedback: momentum traders buy winners, pushing prices higher - Overconfidence: traders extrapolate trends too far - Herding: traders copy each other's positions Momentum crashes Momentum strategies can crash abruptly when trends reverse. A rising stock can suddenly fall, causing momentum traders' stops to be hit simultaneously. The 2020 volatility crash partially involved momentum strategy reversals. Measurement Momentum is measured as past return over a time window (e.g., past 6 months). Stocks with high momentum are long candidates; stocks with low momentum are short candidates. Practical example A stock has risen 20 percent over the past 6 months. A momentum trader buys the stock, expecting continued rises. If the trend continues, the trade is profitable. If the trend reverses (perhaps due to new information), the trade loses. Momentum versus value Momentum trading and value investing are opposites. Value investors buy falling stocks, betting on reversals. Momentum investors buy rising stocks, betting on continuation. See also - Trend Following - Mean Reversion - Technical Analysis - Herding
