Trading Momentum
Stockscores.com Perspectives for the week ending August 4, 2006
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In this week's issue:
If you have been around the market for some time you will have heard about momentum indicators and momentum traders. But what does it mean to trade momentum and how do you do it? Here are some things to think about for aspiring momentum traders.
The most common momentum indicator is a MACD, which stands for Moving Average Convergence Divergence. It measures how two moving averages of different time frames (a short and a long term) are moving relative to one another. It is useful because it captures the essence of a trend, which is that a short term moving average is above the longer term moving average for an up trend and below for a downtrend and, it measures whether the trend is increasing or decreasing its slope.
I am not a proponent of using any technical indicator for measuring momentum, not because there is anything wrong with something like the MACD but because I think reading the price patterns on a stock chart provide greater insight in to who is winning in the market. The stock market is a war between buyers and sellers and when one side is winning a battle on an individual stock, the stock will gain momentum. Buyer winning provides upward momentum and downward momentum occurs when the sellers are in control.
Therefore, when looking at a stock chart and trying to gauge momentum you really need to ask one simple question, "Who is in control of the market, the buyers or the sellers?"
There are actually three answers to this question. The first answer is that the buyers are in control, and this occurs when there are rising bottoms on the stock chart. A bottom occurs anywhere the direction of the trend changes. It happens when the stock stops going down and starts going up. Over a stock's long term up trend there will be a series of short term downtrends. If each consecutive short term downtrend makes a higher high on the pullback, you have a chart showing rising bottoms.
Falling tops indicate the sellers are in control. Draw a line that lays across the tops of the chart. If that line slopes down from left to right, you have a chart with falling tops and therefore downward momentum.
The third answer is that no one is in control of the market. This occurs when a stock is trading sideways or perhaps jumping all over the place without a clear cut trend. This is when the insane are in control of the asylum, making the stock difficult to predict and trade and therefore are best avoided.
The successful momentum trader is able to identify the point when the momentum is changing, allowing them to get in to a new trend early and stay in that trend for most of its duration. A good momentum trader takes trades with small downside risk and large upside gain, making it unnecessary to be right most of the time because the gains when they are right far outweigh their losses when they are wrong.
There are two key steps in a trend reversal. Step one is a break of the trend. If you are looking for a break of the down trend then you are looking at the chart for a price break above the line that you have drawn to connect the falling tops. A break of the upward trend occurs when the line drawn across the rising bottoms is broken by price.
Entering at step has less chance of success but lower risk. When you buy stocks that have broken their downward trend line, you put your stop loss point at the bottom of the down trend. If you are wrong about the trend reversal, the stock will go to new lows and you will have to take your loss.
Step two in a trend reversal is a break from a rising bottom (for the start of an up trend) or a break from a falling top (for a downward trend). This is a better show of momentum change but because you are now farther away from the extreme high or low of the trend, the trade is more risky here.
Generally speaking, up trends change direction more quickly than down trends. Fear is a more powerful emotion than greed so often up trends switch to sharp and quick sell offs, making a short of a break in the upward trend line worth considering. Down trends tend to bottom more slowly meaning that the market rarely makes V bottoms.
The momentum trader does not try to find the bottom or the top; they try to enter the trade near the bottom or the top but with a higher probability of success. They can buy the break of the downward trend or the break from the first rising bottom. They can short sell the break of the upward trend or the break down from the first falling top. This approach to momentum trading gets them in to the trade before the larger crowd who tend to wait for the trend to further progress. When the general investment population is coming in to a stock it is time to start watching for the exit signal.Back To Top
I ran the Breaking Downtrends strategy Market Scan this week. This scan looks for an abnormal move to the upside against a pessimistic long term down trend. From the Market Scan results, we must look at each chart to see if the long term downward trend line has been broken. Buy the trend line break and put a stop loss order at the low to protect against a big loss if we are wrong (although a gap down through the stop could happen and make the small loss larger).
Two stocks came up from this scan Friday, both have good trend line breaks because they also have a slight rising bottom in to the break of the downward trend:
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1. SCON
SCON made a good move higher on decent volume, the downtrend was broken after the stock failed to make a new low earlier this week. Support at $1.35
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2. GTRE
A new low was hit a few weeks ago and the stock has been holding above that low since. Friday, the stock broke its long term downward trend line with more volume than normal and looks like a good candidate for a trend reversal. Support at 2.82.
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References
Get the Stockscore on any of over 20,000 North American stocks.
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Strategies that can help you find new opportunities.
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See which sectors are leading the market, and their components.
Disclaimer
This is not an investment advisory, and should not be used to make
investment decisions. Information in Stockscores Perspectives is often
opinionated and should be considered for information purposes only. No
stock exchange anywhere has approved or disapproved of the information
contained herein. There is no express or implied solicitation to buy or
sell securities. The writers and editors of Perspectives may have positions
in the stocks discussed above and may trade in the stocks mentioned. Don't
consider buying or selling any stock without conducting your own due diligence.
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