The idea
Many studies across different markets have noticed that stocks which outperformed others over a period such as 6 or 12 months sometimes keep outperforming for a while after. That is a general tendency seen in past data, not a rule that holds for every stock or every period. The momentum strategy turns the observation into a rule: rank stocks by their return over a fixed period, using prices adjusted for corporate actions (such as splits, bonus shares and rights issues), hold those at the top, and review the ranking periodically. To compare the investor's total return, use total return, which includes dividends too; the raw price of a stock that split can look 50% down without the holder losing anything.
Example: two months in a row
The difference from trend following: a stock can still be in an uptrend and drop off the list because other stocks rose more. Momentum measures relative strength, not the trend on its own.
How does it fail?
One of the best-known failures is a sudden reversal: the stocks that rose most are sometimes the ones that fall fastest when market mood turns, and the strategy notices late because it looks at past performance. There is also the trading cost at every review, and thinly traded stocks can jump to the top of the ranking on a big move made with small quantities.
Compare performance over different periods
Pick a group of stocks, open each one's chart over the same period, such as 6 months, and compare their change the same way. Then switch the period to one day, and you will see the order changes a lot.
Check yourself
1. What is the main difference between momentum and trend following?
2. Why does each review of the list carry a cost?
Summary
- Momentum ranks stocks by past performance and holds those at the top.
- The strategy needs periodic review, and each change to the list carries a trading cost.
- Its biggest risk is a sudden reversal, because it looks at past performance.