Momentum strategy: types, rules and an example

Written by the Tactfolio research teamPublished 7 min read

A momentum strategy is a set of rules that buys what has risen the most lately and avoids what has fallen. It measures past returns, often over 3 to 12 months, and checks again on a fixed schedule, such as once a month. It can rank single stocks, sectors or whole asset classes. Many momentum strategies also step aside into bonds or cash when everything is falling.

Key points#

  • A momentum strategy is a written rule, not a hunch about one hot stock.
  • Every momentum strategy makes five choices. They are what to pick from, how far back to look, how many to hold, how often to check, and where to hide.
  • Relative momentum picks the strongest assets. Absolute momentum asks whether an asset beat cash at all. Dual momentum uses both.
  • Research has found momentum in stocks, bonds, currencies and commodities (Moskowitz, Ooi and Pedersen).
  • Momentum strategies can lose badly in sudden crashes and sharp rebounds. A monthly check cannot react to a fall that takes a few weeks.

How is a momentum strategy different from momentum stocks?#

Momentum stocks are the stocks themselves: the recent winners. A momentum strategy is the full set of rules around them. It says which list to rank, when to buy, when to sell and what to do when nothing looks strong.

Many popular momentum strategies don’t hold single stocks at all. They rank a handful of funds, such as US stocks, foreign stocks, bonds and gold, and hold the leaders. That keeps trading low and spreads risk across whole markets.

The main types of momentum strategy#

TypeWhat it ranksWhat it holdsExample
Stock momentumHundreds of single stocksThe strongest stocks, reset on a scheduleA momentum ETF such as MTUM
Asset class rotationA few funds, such as stocks, bonds and goldThe strongest one to threePapa Bear Portfolio
Absolute momentumOne asset against cashThe asset while it beats cash, else bonds or cashCross-Asset Momentum
Dual momentumTwo or more funds, then cashThe stronger fund, but only while it beats cashDual Momentum
Breadth momentumA group of risky fundsThe leader, or bonds if any one fund is fallingVigilant Asset Allocation

Absolute momentum is close to trend following. Both ask one question: is this asset going up? Relative momentum asks a different one: which asset is going up the most?

The five choices in every momentum strategy#

  1. The list. Which stocks or funds the rule can pick from. A short list of broad funds is simpler and cheaper to trade.
  2. The lookback. How far back to measure returns. Twelve months is the most studied. Shorter lookbacks react faster but switch more often.
  3. How many to hold. Holding one asset gives the biggest swings. Holding three or more smooths the ride.
  4. How often to check. Most fund strategies check once a month. Checking more often adds trades and costs.
  5. The safe asset. Where the money goes when nothing qualifies: Treasury bills, short-term bonds or long-term bonds.

Small changes to these choices can change results a lot. That is why it pays to test a few versions, not just the one that looks best.

A momentum strategy example#

Here is a simple dual momentum rule, based on Gary Antonacci’s Global Equities Momentum. On the last trading day of each month:

  1. Compare the 12-month return of US stocks with that of Treasury bills.
  2. If US stocks beat bills, hold whichever of US stocks and foreign stocks rose more.
  3. If not, hold bonds.

Now say these are the 12-month returns at the end of a month. The numbers are made up to show how the rule works:

AssetFund12-month return
US stocksSPY+14%
Foreign stocksVEU+9%
Treasury billsBIL+4%

US stocks beat bills, so the rule stays in stocks. US stocks also beat foreign stocks, so it holds SPY for the next month.

A month later, say US stocks are up only 2% over 12 months, while bills are up 4%. Stocks no longer beat cash, so the rule sells SPY and holds bonds. It checks again at the next month end.

What does the research say?#

Two kinds of research back momentum strategies.

  • Relative momentum. Jegadeesh and Titman ranked US stocks by their returns over 3 to 12 months. The best ones tended to keep beating the worst for months after (Journal of Finance).
  • Absolute momentum. Moskowitz, Ooi and Pedersen studied futures on stock indexes, bonds, currencies and commodities. Those that rose over the past year tended to keep rising the next month (Journal of Financial Economics).

Later work found a cost. Momentum’s worst losses come after a crash, when beaten-down assets bounce back hard (Daniel and Moskowitz). Results can also shrink after a strategy is published. Keller and Keuning’s Vigilant Asset Allocation is one example. Since the paper came out in 2017, it has trailed the S&P 500 in its Tactfolio backtest.

What can go wrong#

  • Fast crashes. A 12-month signal checked once a month can be fully in stocks when a crash starts. Dual Momentum lost about a third in early 2020, according to its Tactfolio backtest.
  • Sharp rebounds. After a fall, the rule may sit in bonds while stocks jump back.
  • Bonds falling too. In 2022, stocks and bonds fell together, so the safe asset did not protect.
  • Whipsaws. When prices chop sideways, the rule can buy high and sell low again and again.
  • Costs and taxes. Each switch costs something. In a regular account, each sale can also mean tax. Inside an IRA or 401(k), switches don’t trigger tax.

Momentum strategies you can study#

Tactfolio rebuilds published momentum strategies from their authors’ own rules. Each page shows the rules and a hypothetical backtest, including the bad years:

Common mistakes#

  • Picking the lookback that tested best. The best past setting is often luck (why past results mislead).
  • Judging a strategy by its best years. Look at its worst drawdown and how long it took to recover.
  • Ignoring what happens after publication. Many strategies did better in the author’s test than they did later.
  • Using a long list of similar funds. Ten stock funds that move together give a false sense of choice.
  • Abandoning the rule after one bad year. Every momentum strategy has long stretches of trailing the market.

Try it on Tactfolio#

Tactfolio’s builder has a Rank block made for momentum. It scores assets by their past returns and keeps the leaders. The common patterns guide shows how to combine it with a test against cash. Start from Dual Momentum, copy it, and try a shorter lookback or a different safe asset. Then compare the backtests side by side in the strategy builder. Every backtest is compared with an S&P 500 fund, so you can see whether the extra rules paid for themselves.

Common questions#

Do momentum strategies work?#

Research has found momentum across many markets and many decades. But returns come in uneven bursts, with years of trailing the market and sharp losses after crashes. Many strategies have done worse since they were published. Past results don’t promise future ones.

Is momentum the same as trend following?#

They overlap. Trend following asks whether an asset’s price is going up, often using a moving average. Absolute momentum asks the same thing using past returns. Relative momentum is different, because it compares assets with each other.

How often should a momentum strategy trade?#

Most fund-based momentum strategies check once a month and switch only a few times a year. Checking every week reacts faster but adds trades, costs and false signals.

What is the best momentum strategy?#

There is no single best one. Simple rules like Dual Momentum are easy to follow but hold one fund at a time. Rules that hold several assets swing less. Compare the worst drawdowns, not just the returns.

Can I automate a momentum strategy?#

Yes. A momentum strategy is a fixed rule, so software can check it on schedule. On Tactfolio you can build one, backtest it, and run it in a paper account or your own Alpaca account.

Sources

Put it into practice