Momentum trading: spot a trend and ride it to profits

Momentum traders aim to find trends in the markets and profit from them. So how does momentum trading work, and is it effective? Tim Bennett reports.

We favour value investing here at MoneyWeek. Find an asset that's cheap and buy it, then sit on it until the market wakes up to that fact, and sell for a profit. Long-term studies suggest that it's effective, but it does take a lot of patience, and a fair bit of time perusing balance sheets and other data.

But what if none of that matters? That's what momentum traders (or trend followers') think. All that matters to them is where the price is heading up or down and the strength of the trend. As Michael Covel, author of Trend Commandments, notes on "There is no need to figure out why a market is trending, just follow it." So how does it work and is it worth trying?

Momentum traders argue that current prices in most liquid, efficient markets already reflect everything that the market knows about a stock, bond, commodity or currency. So you are wasting your time trying to spot bargains. Worse still, in your hunt for them, you will be distracted by all kinds of irrelevant money-wasting noise' from analysts and stock tippers trying to draw you into the next hot trade.

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A better approach, they say, is to identify a price trend in any market and follow it. You buy when prices are clearly rising, and sell once you get a clear signal that a price trend has reversed. Using derivatives, momentum traders can also follow down-trends and make money by short-selling. So what is a price trend and how do you spot one?

The precise techniques employed by many trend-following fund managers are closely guarded secrets. But one simple way to spot a rising trend is to compare the current price to a historic one when the former is above the latter, you have an uptrend. As Chris Clarke of trend-following firm Lawrence Clarke says: "The best possible indication a market may go a lot higher [is that] the price is going up!"

You can't rely on just two price points. Moving averages aim to smooth out fluctuations to reveal the underlying trend. For example, a 50-day average price is just the last 50 days of price data (for, say, the FTSE 100) added up and divided by 50. To get a moving average for the next 50-day period, you include the new day 51 and leave out day 1, recalculate the average and compare to your first reading. If the latest number is higher you have a rising moving average.

Having spotted a rising trend, the trick is to buy, then ride it out. As Clarke says: "Markets move a lot further than people anticipate." For over 500 years investors have been acting in herds to drive prices up or down.

Does it work? The picture is mixed. Funds that employ trend-following and use derivatives to boost returns suffer from the same drawbacks as many other hedge funds they charge high fees and, because many bet huge amounts on their chosen trend, many fail. Indeed, a report by MIT economist Andrew Lo, quoted in the Financial Times, suggests that 14% of this type of fund close every year.

As for the returns they often promise, another report, entitled Fooling Some of the People All of The Time, by three US academics, suggests that adjusted for sector-wide high fees the average return drops below those from US Treasuries. Not a sector for widows and orphans.

But one fund that is worth a look, a favourite of our regular writer Tim Price, is the Bluecrest Bluetrend fund (LSE: BBTS). Up until last year (when it was essentially flat in "the toughest market I've ever encountered", says Tim), it managed a double-digit return (averaging 16.58%) every year since its launch in 2005.

It aims to return 15%-20% annually, net of fees. This looks ambitious, but nonetheless, for Tim, this is the trend-following fund to own if you don't mind taking some risk.

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.