Momentum: Riding the Trend
The Idea: Trends Tend to Continue
If a stock went up last week, it's more likely to go up this week. This is called momentum — the tendency for price movements to persist.
Why? Markets don't process information instantly. When good news hits, prices drift up over days/weeks as traders learn about it. This drift creates a trend we can exploit.
Simple rule: Buy what's been going up, sell what's been going down.
Momentum exploits slow information diffusion in markets. It's strongest in trending markets and weakest when prices revert (opposite next lesson).
The return over the last days. Long when M > 0, short when M < 0. Typical lookback: 20 trading days.
Why does momentum work as a trading signal?
If momentum_20 = +25%, what's the signal?
Momentum signal: return over last days (typically 20)
Long when momentum > 0, short when momentum < 0 — bet the trend continues
Why it works: Slow information diffusion causes price drift; trends persist short-term
Trade-off: shorter lookback = more trades (reactive); longer lookback = stable signals but miss early entry
Works in: Trending markets; fails in: choppy, mean-reverting markets
Real use: Rank 500+ stocks by momentum, go long top 50, short bottom 50 (cross-sectional momentum)