Key Takeaways
- Momentum trading attempts to profit from trends in motion
- In 2024, momentum was the best-performing equity factor—but historically, top years are often followed by negative returns
- Success requires precise timing and the ability to exit before reversals
What is Momentum Trading?
Client Question: "I heard momentum trading works—stocks that are going up keep going up, right?"
Important Framing: This lesson describes common day trading strategies to help you understand what clients are doing. These are categories of behavior, not recommendations.
The Core Idea
Momentum traders believe that stocks moving strongly in one direction will continue moving that way—at least for a while. They try to "ride the wave" by:
- Buying stocks that are rising
- Selling (or shorting) stocks that are falling
- Exiting before the momentum reverses
What the Research Shows
2024 Performance: In 2024, the momentum factor was the best-performing equity factor in U.S., international developed, and emerging markets. By year-end, U.S. momentum's excess returns were in the 96th percentile of all periods in the last 50 years.
| Metric | 2024 Value |
|---|---|
| Percentile ranking | 96th (highest since 2000) |
| Momentum vs. S&P 500 | Significant outperformance |
| P/E ratio of momentum stocks | 28 (33% above historical average) |
But here's the catch:
| Historical Pattern | What Happened Next |
|---|---|
| When momentum was the best factor | Negative excess returns the following year in 7 of 11 cases |
| Average following-year return | -5% excess return |
| Current valuation | Momentum stocks trading well above historical averages |
Academic Research on Intraday Momentum
A 2024 academic study examined an intraday momentum strategy on SPY from 2007 to early 2024:
| Metric | Result |
|---|---|
| Total return (net of costs) | 1,985% |
| Annualized return | 19.6% |
| Sharpe Ratio | 1.33 |
Important context: This study was conducted by quantitative researchers with sophisticated tools, not retail day traders using standard platforms. The strategy required precise execution and constant monitoring.
Why Clients Are Drawn to It
Momentum trading appears straightforward: "buy things going up." This simplicity is appealing but masks the difficulty of:
- Identifying genuine momentum vs. random fluctuation
- Timing entries before the move is over
- Recognizing reversal signals before giving back gains
- Avoiding the momentum crash—when momentum suddenly reverses
The Momentum Crash Risk
Momentum strategies are vulnerable to sharp reversals. When market sentiment shifts quickly, momentum stocks can collapse faster than they rose. This happened dramatically in:
- The 2009 market recovery
- The 2020 COVID recovery
- Various sector rotations
Professional Framing
When clients ask about momentum trading:
"Momentum has been one of the strongest market factors historically—stocks that have been rising do tend to continue rising, on average. But there are two challenges: knowing when the momentum will reverse, and the fact that strong momentum years are often followed by weak ones. In 2024, momentum was in the 96th percentile of historical performance. Historically, when momentum has been this strong, the following year has been negative more often than not."
What This IS / What This IS NOT
| This Lesson IS | This Lesson IS NOT |
|---|---|
| A description of what momentum trading is | A recommendation to try momentum trading |
| An explanation of historical research | Advice on which momentum stocks to buy |
| Context for client conversations | A trading strategy guide |
According to historical data, when momentum was the best-performing factor in a given year, what typically happened the following year?