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Tap These 5 Momentum Picks for Big Profits
Zacks Equity Research
Updated

What in basketball we call a “hot hand,” a player making a few shots in a row, in finance parlance, we have a word for it. It’s called “momentum.”

Momentum is basically the tendency of winning stocks (i.e. stocks that have outperformed the market in recent times) to keep winning and losing stocks to keep losing. It is based on the idea that once a stock establishes a trend, it is more likely to continue in that direction than move against the drift.

At the core, momentum investing calls for investors to “Buy High, Sell Higher.”

Momentum vs. Other Styles

It is worth pondering over how the momentum strategy compares to other styles of investing over time. Recent research indicates that the size premium for small-cap stocks has shrunk dramatically since the 1980s; value premium has also declined dramatically since the1990s. Academics are of the opinion that once research on factor premiums (like size and value) become known to the public, the investment world catches on and the premium is gradually eroded.

However, unlike other investment styles, the momentum premium has remained remarkably robust and persistent ever since it was identified by financial academics in the 1990s.

But Why Does Momentum Strategy Work?

There’s a whole laundry list of behavioral biases that most investors exhibit, and these emotional responses and mistakes are the very reason that momentum strategy works. For instance, we all know of investors who are afraid to book losses, and hence hold onto losing stocks for too long, hoping that they will come back to their original prices. On the other hand, investors sell their winners way too early.

Furthermore, investors initially tend to under-react to news, events or data releases. However, once things become clear, they tend to go with the herd and overreact, causing dramatic price reactions.

These behavioral issues extend trends, and thus open up a huge opportunity for momentum players to make profits. So, it’s a way to profit from the general human tendency to extrapolate current trends into the future.

Momentum investing is based on that gap in time that exists before the mean reversion occurs, i.e. before prices become rational again.

Chase the Alpha

Momentum strategies have been known to be alpha-generative over long periods of time and across markets. So obviously, this strategy is quite tricky to implement, as detecting these trends is no child’s play.

Here, we have created a strategy that will help investors get in on these fast movers and make handsome gains. Our screen will help you to take advantage of both long-term price momentum and a short-term pullback in price, which would reflect some profit-taking in the stock.

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