How Trading Momentum Gives you an Edge - Part 1


Momentum is the ability of a stock to outperform against other stocks. It is a result of an expectation by market participants of a higher valuation of any given stock or group of stocks. This expectation can be valid or not valid (irrational exuberance). As momentum traders, we do not look at things like P/E ratios, we focus on whether a stock has momentum and if that momentum will continue.

Past research has proven that momentum does exist in the market. Refer to my research page located at: http://patientfisherman.blogspot.com/2010/09/research-papers-momentum.html

You can also read several books to get a thorough understanding on momentum and its inner workings:
  • How To Make Money in Stocks - William O’Neil
  • Smarter Investing in Any Economy - Michael Carr
  • Beat The Market - Invest By Knowing What Stocks to Buy and What Stocks To Sell - Charles Kirpatrick
Momentum can occur as a result of superior earnings, new sales agreements, supply shortages, earnings guidance, regulatory changes and any other event that can lead to the possiblity of increased earnings on any stock or group of stocks.

The Key to trading momentum, is to believe that momentum exists and stocks or group of stocks can outperform all others during certain time frames. We buy high and sell higher.

Momentum can occur on any time frame, 5 days, 1 month, 6 months or a year. Using Bluefin, we try to take advantage of momentum movements by focusing on groups of stocks with momentum, known as sectors.

Basically, we are looking for a relative strength calculation which measures the performance of price from today to some point in the past. You can then take this value and rank it against a set of stocks to find out which stocks outperform across the group.

In its most basic form relative strength can be calculated by
Price Today - Price X Months ago / Price X Months ago * 100

If you wanted calculations across multiple time frames in Telechart it would look like this:
100*(c-c21)/c21 for 1 month
100*(c-c126)/c126 for 6 month
100*(c-c252)/c252 for 12 month

In Bluefin, we use the MDT calculation created by Pradeep Bonde over at StockBee. We apply this formula to all stocks and sectors and then rank those stocks and sectors on various conditions to generate our Emerging 50 and Sector 50 watch lists.

By using momentum calcuations in Bluefin, we can keep our money in the best performing stocks, significantly outperforming the market indexes.

In the next article about momentum, I will walk you through setting up the relative strength calculations in Telechart and then cover some recent examples of momentum trades found in Bluefin.

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