Momentum trading is a strategy where an investor tries to capitalize on a stock's trend in hopes of riding the move further. Using these guidelines, momentum investors can rack up startling returns.
We’ve all seen what can happen when an index, sector or stock catches momentum — either to the upside or downside. However, momentum waves don’t move uniformly. They bounce up and down in a general upward trend, gradually making new highs and higher lows, or they fall in a general downward trend.
While the momentum trading concept is nothing new, the introduction of the online momentum day trader in 1996 kicked it up several notches and helped create unprecedented volatility in the markets.
And being able to nail down stable, predictable, repeated price patterns gave birth to a wave of momentum-based traders. Individuals could suddenly thrash Wall Street, with some “Average Joe” day traders becoming millionaires by raking in 458% on Qualcomm (Nasdaq: QCOM) or 608% on Yahoo! (Nasdaq: YHOO) in just six months in 1999.
Of course, the consistent returns of momentum investors baffled “efficiency theory” economists and stuffy Nobel Laureates who claimed the markets move randomly, like bacteria in a Petri dish. Study after study showed stocks in upward-momentum price patterns are more likely than other stocks to keep rising. Here is a recent slap in the face of the ivory-tower geezers from the best and brightest of the “young punk” finance professors:
Moskowitz, T., Clifford Asness and Lasse Pedersen, “Value and Momentum Everywhere,” Journal of Finance (2012).
Finally, they’re admitting they’ve been wrong. The key is to find a momentum model that works. And here it is…
Beating the market with momentum
In short, momentum trading is holding a fast-rising stock for a few days, weeks or months.
It’s a strategy where an investor tries to capitalize on a stock’s trend (be it on the long or short side) in hopes of riding the move further. And it’s less risky than momentum day trading, where you’re “in-at-dawn” and “out-in-the-afternoon,” as long as you follow the rules below.
Momentum trading is most powerful when cash on the sidelines starts to pour into the market once it’s fully recovered from a crash. For instance, it was particularly profitable from 1996 through 2000 — nine years after the 1987 crash. And the recovery from the 2000 crash was much faster, as momentum investors racked up startling returns from 2003 to 2007, using the guidelines I’m about to explain…
The five characteristics of momentum
The beauty of momentum stocks is there are very simple ways to find them…
Momentum Stock Factor #1: Rising Trend
One of the key traits of a good momentum stock is a rising stock price for a few weeks or even months.
Solution: Target stocks in a recently rapid-rising uptrend. You can see this by looking at a daily, weekly, or monthly chart looking back over the prior 12 months. The stock is in an uptrend if the current price is higher than any price over the last year.
I’ll also be introducing a special stealth bomber tool, which Gecko designed just for my trading, for spotting momentum stocks. It is top secret for now. I guarantee it will blow your mind.
It is currently a top secret project in the Gecko Software workshop, code-named “Chart Miner.”
Momentum Stock Factor #2: Institutional Ownership
The real forces behind stock market momentum are the big institutional players, mutual funds and hedge funds that trade in and out of stocks slowly, compared to the momentum players.
Solution: When large investment houses buy and hold huge blocks of shares, it exerts heavy upward pressure. So look for a strong trend that institutional ownership has been recently increasing.
Investors.com offers up an ACC/DIS rating that tells you the recent trend of institutional ownership. Look for values greater than a B-. You’ll find it in their “Smart Select Ratings” once you mash in the stock symbol and hit go.
However, you need to make sure institutions don’t already own too much stock. You don’t want a bunch of paper-profit-rich fund managers who are eager to dump on the public.
Look for stocks where institutional ownership is rising, but the percentage of ownership is low. Ideal levels are stocks with 5% to 25% of institutional ownership. You can find this by looking at Yahoo! Finance under “Major Holders.”
Then look at “% of Shares Held by Institutional & Mutual Fund Owners.”
Momentum Stock Factor #3: Earnings Surprises
Academic studies of a phenomenon called the “post-earnings announcement drift” have shown that you should search out companies that have beaten analysts’ earnings expectations. Those stocks are the most likely candidates for stellar momentum-based returns over the course of a few weeks or months.
Solution: Look for companies that are consistently surpassing analysts’ earnings expectations. Investors.com gives you this information. Click on the “Get IBD Checkup For [Symbol]” button.
Then look for the line that says, “Last Quarter % Earnings Surprise.” You want it to be double-digit positive.
Momentum Stock Factor #4: Brace for Price Reversals (Know When to Fold)
The same studies I mentioned above also show momentum stocks can unexpectedly reverse into a downtrend. For this reason, you should never buy and hold a momentum stock.
Instead, use moving averages as an exit signal. (I recommend five days for the fast-moving average and 20 days for the slow one.) If you see the fast-moving average drop below the slow-moving average, get out immediately.
Track N’ Trade gives you this and a ton more in their technical tools plugin. Their Bulls N’ Bears tool is unlike any oscillator I have ever seen. Make sure you check it out.
An even simpler strategy is to trail your stop below the support of the current or prior price consolidation. Don’t crowd the position.
Legendary momentum trader Nicolas Darvas trailed his stops as wide as 19% once his position became profitable.
Solution: Watch for a crossover where the fast-moving average crosses below a slower-moving average.
Momentum Stock Factor #5: Use Trailing Stops
A big problem with momentum stocks is they often drop like a rock after reversing. For that reason, you should always place an initial stop below your entry price. This doesn’t mean you’ll necessarily exit there; you’ll most likely sell on the moving average exit signal before this.
Look for prior price consolidations on a Track N’ Trade High Finance daily chart. Determine the amount you’d lose if the market hit your stop.
Setting your stops relative to a prior price consolidation allows you to ratchet down your initial risk. Nicolas Darvas used an initial stop that was normally about 5% below his entry price. Very occasionally he accepted a risk up to 9%.
Well-known contemporary momentum trader William J. O’Neil never sets an initial stop lower than 7% below his entry point. This may sound impossible to you if you’re not used to using chart patterns to set your initial stops. This is quite easy once you learn how.
Solution: Stops protect you from heavy losses and take the emotion out of the sell decision.
You can spot likely momentum-trading suspects by visiting The Wall Street Journal’s NYSE Biggest Percentage Gainers list. One warning though…
I readily admit this list is for chumps.
Scott Brown, PhD, is Investment U’s Education Director and a professor of finance at the University of Puerto Rico.