In trading, you’re often told to “buy low, sell high.”
But what if I told you some of the most profitable traders do exactly the opposite?
Welcome to the world of momentum trading, where you buy stocks that are soaring, betting they’ll climb even higher. It sounds counterintuitive (and even reckless), but the data tells a different story.
Over the past 25 years, a simple momentum trading system has returned a staggering 6837%—turning a $10,000 investment into nearly $700,000. Want to learn more?
That’s what today’s post is all about.
You’ll discover…
- What momentum trading is about (how and why it works)
- The principles behind momentum trading success
- A momentum trading system that has generated 6837% over the last 25 years
- Data and backtest results
- Pros and cons of momentum trading (yes, there are cons—nothing’s perfect, just like my hairline)
Sounds good?
Then let’s dive faster than I dive into a buffet line…
Momentum trading explained
The idea behind momentum trading is simple: an asset price that has momentum tends to continue moving in that direction. Thus, a momentum trading strategy looks to buy when the price is high, with the hopes of selling it at an even higher price (buy high and sell higher).
It’s the same reason why I can’t stop after eating one potato chip.
So, why does momentum trading work?
There are three main reasons for it…
Post-earning drift
When a company posts great earnings, the stock could jump 10% in a day. Over the next few days, analysts upgrade the stock to a “Strong Buy” (which is analyst speak for “We totally missed this but will pretend we knew all along”). This brings in more capital from institutions and retail players and thus pushes the price even higher.
Fear of missing out (FOMO)
When the stock price moves higher and gets talked about often, more people join the bandwagon because of the fear of missing out (FOMO). This adds more buying pressure and fuels the move further.
Institutional flows
Big institutional funds are not able to enter a position all at once, or else they end up moving the market. So, they scale their positions gradually over weeks (and sometimes even months). This creates persistent buying pressure, like me persistently eating chips—one after another after another…
Now, before I give you the rules of the momentum trading system, you first need to understand the principles behind it so you know how it works.
5 principles of momentum trading
1. The overall market is bullish
Before you identify the stocks with momentum, make sure the overall market is bullish. That’s because a rising tide lifts all boats. This means in a bear market, even a strong momentum stock is likely to falter.
2. Identify stocks with the strongest momentum
You might be wondering: “How do I measure momentum?”
There are a few ways to do it. The easiest is to calculate how much % the stock price has increased over a fixed period. E.g. the stock price increased 20% over the last 20 days.
Based on academic studies (Jegadeesh & Titman, 1993), stocks that exhibit the strongest momentum over the last 6 to 12 months tend to continue moving higher.
3. Exit when momentum gets weaker
Momentum doesn’t last forever (just like my New Year’s resolution).
Eventually, the stock “runs out of gas”, and that’s when the price stalls (or sometimes even reverses completely). This is where you exit the trade.
Think of momentum trading like onboarding a rocket ship. You stay with it when the momentum is strong. But when momentum stalls, it’s a sign the rocket ship has run out of fuel. That’s when you hop off the rocket ship and find the next best one.
4. Replace with strong momentum stocks
After you exit the trade, what’s next? Well, you identify new momentum stocks and get on board the next rocket ship! It’s like dating in my younger days—always looking for the next best thing.
Don’t tell my wife I said that.
Think of your portfolio like a sports team: you always want your top players on the field, and you sub out the weak ones. Nobody wants to keep a goalkeeper who uses his face instead of his hands to stop the ball.
This process will repeat itself unless it’s a bear market. When that happens, you’ll stay in cash so you can avoid the nasty drawdowns. This means you can sleep peacefully at night while the rest of the world is panicking with fear.
5. Trade multiple stocks
Anything can happen to a stock price. For all you know, the company is fraudulent, and the stock price goes to zero. That’s why, as a trader, you shouldn’t allocate all your capital to a single stock because anything could happen.
Instead, spread your bets across multiple stocks so you reduce your risk and have a higher chance of making a profit. It’s like having multiple kids—if one disappoints you, you’ve still got backup.
Just kidding, my children are perfect… if you’re reading this.
These five principles form the backbone of momentum trading. But principles alone aren’t enough— you need clear objective trading rules.
That’s why I’ll now walk you through the rules of a momentum trading system (backed by data)…
A momentum trading system that works
Markets traded:
Stocks in the Russell 1000 index
Timeframe:
Monthly
Risk management:
10% capital for each stock and a maximum of 10 positions
Trading rules
- The Russell 3000 index is above the 10-month moving average (to know when the overall market is bullish).
- Rank the top 10 stocks that have increased the most in price over the last 40 weeks (to define strong momentum stocks).
- Buy the top 10 stocks using a market order (the entry).
- Sell the stock when it falls out of the top 30 ranking and replace it with the next strongest momentum stock (the exit signal)
- Sell all positions when the Russell 3000 closes below the 10-month moving average (to know when to stay in cash)
Backtest results: Momentum trading system
Here’s the result over the last 25 years…
- Total return: 6837% (since 2000)
- Annual return: 18.47%
- Winning rate: 51.88%
- Losing rate: 48.12%
- Payoff ratio: 2.12 (average profit / average loss)
- Maximum drawdown: 49.44%
Here’s the equity curve of the trading system…
And the yearly returns…
Here’s what one of my students, Darren (from The Ultimate Systems Trader), has to say about a momentum trading approach…
“My MOMO portfolio is up more than 40% since I started this system in June.” — Darren
Moving on, let’s talk about the pros and cons of momentum trading…
Pros and cons of momentum trading
First, the advantages of momentum trading…
Advantages of momentum trading
- Exposure to the best-performing stocks
- High profit potential
- Minimal time required
Unlike investors who have to analyse financial reports and follow the news so they can be exposed to the best performing stocks, a momentum trading system allows you to automatically get exposure to them without any of that “work”. That’s because you use price as the signal to tell you what’s hot and what’s not.
Because you’re always buying the strongest stocks and selling the weaker ones, you have a huge profit potential. It’s not uncommon to see your stock rally 200%.
And finally, for this type of momentum trading system, you only trade once per month. This gives you the freedom to do the things you love without having to analyse financial reports, study chart patterns, or follow the news.
Next, the disadvantages…
Disadvantages of momentum trading
- Steep drawdown
- It might be psychologically hard to pull the trigger
You only trade once per month (on the 1st trading day of each month). This means if the market makes a sudden decline during the month, you still have to hold your positions. If the market doesn’t recover, you can expect to suffer a drawdown of 40 or even 50%.
As a momentum trader, it can be psychologically hard to pull the trigger because you’re always buying at a “high price”.
I recalled that during March 2020, the stock market tanked 30% because of COVID. Shortly, it bottomed out, and the stock market climbed up towards the all-time high. At this point, can you imagine having to buy stocks when the financial news is filled with negativity?
In times like this, you must tune out the noise, control your emotions, and follow the rules. If you can do it, you’d be up 67% for the year. That’s the power of systems trading because you remove the guesswork and avoid making emotional decisions (which rarely end well).
So now the question is…
Is momentum trading suitable for you?
Here’s my take on it…
Momentum trading is NOT for you if…
- You want a high winning rate (60% or more).
- You are looking for small and consistent gains.
Momentum trading is FOR you if…
- You want to spend minimal time on trading.
- You want to catch big moves in stocks.
- You want high returns and can embrace the volatility that comes along with it.
Now, you have a good idea whether momentum trading suits your personality and goals.
Still, you might have a few questions. So let’s tackle some of the common ones I get from traders faster than I tackle the last slice of pizza…
Frequently asked questions
Can momentum trading be applied to other markets?
Yes. I’ve tested it on stocks, ETFs, and even crypto.
How can I reduce the drawdown of a momentum trading system?
You can adopt multiple trading systems. A good complementary would be a mean reversion trading system.
What’s the minimum capital requirement?
You can get started with $5000.
Can this work on the short side?
I’ve not been able to make it work on the short side and haven’t seen others talk about it either.
Conclusion
Momentum trading works because it exploits human psychology (FOMO) and the structure of the markets (earnings surprises and institutional flows).
When you apply a rule-based approach, you don’t need to predict or rely on gut feel; you simply follow the rules and let the system do the work. It’s like using a GPS instead of asking my wife for directions.
Of course, no trading system is perfect. Momentum comes with volatility and drawdowns, and it requires the discipline to keep buying when it feels uncomfortable. But if you can embrace that, the rewards are worth it because you get exposure to the strongest stocks (the Usain Bolts of the market), outsized returns, and minimal time commitment.
So, if you want to learn how to implement a momentum stock trading system for your portfolio, then check out The Ultimate Systems Trader. It’s a 1-year coaching program that shows you how to earn an extra 15% a year in 15 minutes a day, so you can generate another source of income. Details here.