Momentum Investing

Momentum investing or trend trading stocks is the theory that goes directly against the buy low sell high theory. Instead it tries to buy when prices are high and sell when they get higher. Amazingly it has proven itself time after time to be the most successful way to approach the market.

Successful traders such as Nicholas Darvis (who turned $10,000 into $2,000,000 in 18 months), Jessie Livermore (who has made unrivaled returns in the stock market), and Ed Seykota (Who has made an average of 60% over a 10 year period) all made their amazing gains through trend trading.

So what is it? Simply put it assumes that prices tend to trend in one direction, even if there is no fundamental reason for it to do so. It works similar to a roller coaster ride, when a roller coaster falls down a steep slope it tends to build up momentum, so it can do things like spinning around in loops without actually having to use any mechanical help. The momentum alone is able to push the cart.

Stocks move in a similar way, some good fundamental news can push the stocks up and start an upward trend. The pure momentum of that trend can push the stock higher and higher, well above what the true value of the stock actually is.

Why Does momentum investing Work?

I remember when Oil was breaking all new highs and was trading at many times what it should have been fundamentally. The rumor was that speculators where the ones pushing it up. In reality it was being pushed up by the average investor.

The reason an uptrend tends to continue, is that no one wants to be left out. When a stock starts trending up, investors and mutual fund managers fear that they are going to miss the next big move so they start jumping in. This pushes the stock even higher and so on. The smart traders are not the ones calling a top but the ones who average up when a stock is making a new high.

Common Misconceptions about Trend Trading

There are two major misconceptions about momentum investing.

1. It is Best To Buy Stocks In An Uptrend And Forget it

When most people hear trade with the trend they tend to hear, “Buy stocks that are trending up and hold onto them forever” That isn’t much different than buying and holding random stocks is it? I have also heard things such as buying a stock in an uptrend and holding it for a year as being the best way to approach it.

But in reality if you say, I am going to buy an up trending stock and hold it for X amount of time you are not making the best use of your investment. A good trend trading strategy should attempt to buy an up trending stock and hold onto it until it is no longer trending up, simple as that.

The best trend traders use some sort of trailing stop where they have a stop loss order that moves up as the price of the stock moves up, but does not move down if the stock goes down. This allows you to exit the stock when the trend starts to turn around, rather than ride the stock up and then ride it down.

2. Only Works in a Bull Market

The second biggest misconception about momentum investing is that it only works in a bull market. If you are only looking to ride uptrend to the top this may be true, but trend following allows you to be very successful trading a downward trend as well.

In fact I know from personal experience the month of October 2008 where the SPY had a fall of 23.6% in 1 week was one of the best times to be a trend trader, EVER. Depending on how leveraged you where that month alone could have well over doubled the account if you where following the trend.

In Michael W. Covels book Trend Following he gives some pretty good insights on how trend traders are making huge returns in the stock market right now, as well as gives a few examples of trend traders.

He works pretty hard in the book to show you that trend trading is the best way to approach the market.

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