Leverage The Price Momentum Of These 4 Hot Stocks

It has been two decades since academics zeroed in on what we today call the “momentum effect” in stock markets. 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 instead of moving against the drift. Unlike the hugely-followed Value or Growth styles, this strategy has barely anything to do with the fundamentals of a company, and instead works with the human penchant to extrapolate current trends into the future.

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

Why Does Momentum Strategy Work?

There is a simple reason behind this. It works because we are humans!

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 springback 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 gain clarity, they tend to go with the flowand overreact, causing dramatic price reactions.

These behavioral problems extend trends, and thusopen up huge opportunities for momentum players. So basically, 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.

Momentum versus Other Styles

It is worth reflecting on how the momentum strategy compares to the other styles of investing over time. Recent research indicates that the size premium for small-cap stocks has shrunk dramatically since the 1980s and value premium has also declined radically since the 1990s. Academics are of the opinion that once research on factor premiums (like size and value) become known to public, the investment world catches on and the premium gradually erodes.

However, unlike other investment styles, momentum premium has stood the test of time, remaining remarkably robust ever since it was identified by financial academics in the 1990s.

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 take advantage of both long-term price momentum and a short-term pullback in price, which would reflect some profit-taking in the stock.

Screening Parameters

Percentage Change Price (52 Weeks) = Top #50: This itemselects the top 50 stocks with the best percentage price change over the last 52 weeks.This parameter ensures we get stocks that have appreciated the maximum over the past one year.

Percentage Change in Price (1 Week) = Bottom #10: From the above 50 stocks, we then choose those that are also among the 10 worst performers over a short one-week period.

Zacks Rank #1: No matter whether market conditions are good or bad, stocks with a Zacks Rank #1 (Strong Buy) have a proven history of outperformance. You can see Zacks Investment Research

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Written By: Zacks Investment Research