How Do I Define My Momentum Trading Strategy?

I’ve been seeing “momentum” bandied about so frequently lately that I decided to take a step back and reflect on how I personally define a momentum play. Mind you, I don’t use specific percentage gains/losses to qualify a stock as having or not having momentum, as I personally define it by the stock’s individual and unique behavior relative to its past.

So if you’ve come to learn about momentum trading from someone who has gone so far as build an entire realtime trading app around the notion, you’ve come to the right place. My hope is this documents my own working definition of “momentum” and to a lesser extent the rationale behind building MOMO.

Philosophically speaking…

My belief behind a momentum trading strategy is that when an opportunity is identified as early as possible, carries lower risk of any other active trading strategy while producing the greatest profit. Momentum opportunities also present themselves in a way that lets you reduce (not eliminate) macro market concerns; reducing variables that would otherwise cloud decisions.

Momentum Trading is Primal

As you may have seen given the lack of complicated studies (e.g. EMA, Bollinger bands, Ichimoku cloud) built into MOMO, we are not employing form-fitting algorithms when trying to identify and trade a potential momentum stock. We care primarily about surfacing price movement as quickly as possible via new daily highs or lows and then evaluating its strength. MOMO is purposely designed to not have distractions to try and sway me from monitoring price action. For this reason, I consider momentum trading more primal than strategies which use patterns, studies, or fundamentals. Perhaps not as raw as scalping, but that is very short term and maybe not a strategy to begin with.

Identifying a Momentum Trade

While others may disagree, when I am looking for a momentum trade I feel that several market elements have to align for true momentum trades in such a way that will drive an unnaturally large move. Here are few factors which I feel contribute to a stock entering a period of momentum.

There may or may not be a catalyst to kick off the momentum. It may be subtle, but enough to spark a momentum frenzy.

  • Existing market participants are generally on the wrong side of the trade. This is a supporting element as participants cover their positions or stops get triggered.

  • New entrants are learning of the opportunity and filing in on a consistent basis over days or weeks or they are closing positions due to disbelief that minor news event has sparked such a strong response.

  • Trading algorithms are supportive of the direction or can’t materially break down momentum by increasing volatility.

  • News and media jump on the stocks price movement to give a final surge as those with less timely information chase trades.

The basis behind my prior statement that momentum strategies are low risk and highly profitable comes from a) knowing the stocks behavior - intimately. b) having the tools to act upon your intimate knowledge to identify the abnormal behavior. Obviously trading is very risky and you should always trade with the expectation you could be 100% wrong.

Analyzing momentum starts with defining price trend. Some think momentum is strongest at the earliest stage of a breakout and weakest at the latter stages; just prior to a trend reversal. I wouldn’t make that conclusion so quickly. I think there are elements at play that allow you to identify small, continuous up-ticks that highlight something is at play. The recent activity with Herbalife (HLF) is one account that comes to mind. A couple hours prior to close, HLF was ticking up and when the market closed there was an important Icahn announcement about wanting a 50% stake in Herbalife where it made its jump.

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Had you tried to purchase at the announcement you would’ve been playing with volatile price movement versus exploring the trade during the noteworthy hour or two prior to the announcement. It's situations like these that I consider momentum trading to be a lower risk as the daily chart is at a relative low and positive continued momentum is being observed.

This brings up the valuable point that there is always someone with more timely knowledge than you. They are the ones who can quietly accumulate shares with the comfort of knowing they have pocket aces in the days prior to big moves. They play the same game and look for buying low and selling high or doing the inverse via shorting. While I have no way of knowing, I would suspect this activity is what causes the measured moves as shown in hours prior to the Herbalife Icahn news and I feel MOMO, helps identify these actions better than anything as price movement encapsulates news and events even before publicly announced.

It was not my intent to focus on Herbalife here, but it does highlight my perspective of momentum - more of snowballing or building effect vs. “it just happens”.

If you recall, I mentioned having “intimate knowledge”. “Intimate familiarity” is probably more accurate, as I’m specifically referring to a stocks behavior given time of day, day of week, response to news, etc. and having this familiarity is required and should be part of the framing of your trade in order to uncover momentum trades vs. typical behavior.

Momentum and Price

If you’re looking at price momentum, you’re going to be looking at stocks with measured and continued price velocity, hour after hour, and day after day. This means the stock is making new highs or lows on the day in a manner which, given your intimate knowledge (er. familiarity) identified as atypical. And because I mentioned that I think this occurs due to market imbalance, news, and investors flooding the stock, the sooner you capitalize on the abnormal velocity, the more you profit and less you risk.

Some people prefer not buying at new highs, but buying at a daily top is a calculated decision as you realize that you are entering due to abnormal velocity and using tools that let you identify this sooner than later, and take advantage of others entering positions following you. And for clarification, “new highs” in my context represents new high of the day. (Note: MOMO also supports 52-week highs and denotes them as solid cells, see ARIA in MOMO illustration). Obviously the same is the case for new lows.

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Price vs. Volume

Momentum is a function of price velocity and it is our premise that we make money trading price and not volume. Further since most retail tools don’t show whether the volume is in buying short or long there is room for considerable confusion when factoring in price. That is not to say, we are against using volume and in fact we plan to incorporate into future versions to highlight where the momentum may start losing its velocity and an opportunity to take profits as the volume could indicate mass retail entry promoted by news and highlight the opportunity where others are identifying the price to be as good an opportunity to liquidate their positions while the price is high.

Never forget that volume doesn’t indicate the stock is being only purchased with high volume and increasing price. If it was pure momentum, there should be significant corresponding price gains (or losses). In other words, for every buyer there is a seller.

Using the same premise, we can utilize StockTwits as a good indicator for when news and general awareness of a stock’s momentum is becoming prevalent and as activity grows, possibly a time to consider taking profits. (MOMO integrates Stocktwits into MOMO two different ways to help gain an understanding of what stocks are trending and which stocks people are noticing).

alt A variety of studies and indicators can blur what is really important. MOMO works on the premise of price momentum - where the stock price moves easily and progressively slows as sentiment changes and profit taking or shorting opportunities become apparent.

We are always looking for ways to help scan for momo stocks and new momo strategies. If you have thoughts or want to share your tools, please let us know.

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