To engage in momentum trading, you must have the mental focus to remain steadfast when things are going your way and to wait when targets are yet to be reached. Momentum trading requires a massive display of discipline, a rare personality attribute that makes short-term momentum trading one of the more difficult means of making a profit. Let's look at a few techniques that can aid in establishing a personal system for success in momentum trading.
Techniques for Entry
The impulse system, a system designed by Dr. Alexander Elder for identifying appropriate entry points for trading on momentum, uses one indicator to measure market inertia and another to measure market momentum. To identify market inertia, you can use an exponential moving average (EMA) for finding uptrends and downtrends. When EMA rises, the inertia favors the bulls, and when EMA falls, inertia favors the bears. To measure market momentum, the trader uses the moving-average-convergence-divergence (MACD) histogram, which is an oscillator displaying a slope reflecting the changes of power among bulls and bears. When the slope of the MACD histogram rises, the bulls are becoming stronger. When it falls, the bears are gaining strength.
The system issues an entry signal when both the inertia and momentum indicators move in the same direction, and an exit signal is issued when these two indicators diverge. If signals from both the EMA and the MACD histogram point in the same direction, both inertia and momentum are working together toward clear uptrends or downtrends. When both the EMA and the MACD histogram are rising, the bulls have control of the trend, and the uptrend is accelerating. When both the EMA and MACD histogram fall, the bears are in control and the downtrend is paramount.
Refining Entry Points
The above principles for determining market inertia and momentum are used to identify entry points in a precise style of trading. If your period of comfort corresponds to the daily charts, then you should analyze the weekly chart to determine the relative bullishness or bearishness of the market. To determine the market's longer-term trend, you can use the 26-week EMA and the weekly MACD histogram on the weekly chart.
Once the long-term trend is gleaned, use your usual daily chart and look for trades only in the direction of the long-term weekly trend. Using a 13-day EMA and a 12-26-9 MACD histogram, you can wait for the appropriate signal from your daily comfort zone.
When the weekly trend is up, wait for both the 13-day EMA and MACD histogram to turn up. At this time, a strong buy signal is issued and you should enter a long position and stay with it until the buy signal disappears. By contrast, when the weekly trend is down, wait for the daily charts to show both the 13-day EMA and MACD histogram turning down. Such an occurrence will be a strong signal to go short, but you should remain ready to cover the short position at the very moment that your buy signal disappears.
Techniques for Exiting Positions
The major reason momentum trading can be successful in both choppy markets and markets with a strong trend is that we are searching not for long-term momentum but for short-term momentum. All markets trend within any given week, and the best stocks to trade are those that regularly exhibit strong intra-day trends. With that in mind, you must remember to step off the momentum train before it reaches the station.
As already mentioned, once you have identified and entered into a strong momentum trading opportunity (when daily EMA and MACD histogram are both rising), you should exit your position at the very moment either indicator turns down. The daily MACD histogram is usually (but not always) the first to turn, as the upside momentum begins to weaken. This turn, however, might not be a true sell signal but a result of the removal of the buy signal, which, for the impulse system, is enough impetus for you to sell.
When the weekly trend is down and the daily EMA and MACD histogram fall while you are in a short position, you should cover your shorts as soon as either of the indicators stops issuing a sell signal, when the downward momentum has ceased the most rapid portion of its descent. Your time to sell is before the trend reaches its absolute bottom. As contrasted with a carefully chosen entry point, the exit points require quick actions at the precise moment that your identified trend appears to be nearing its end.
The Bottom Line
As you have probably already noticed, the impulse system of trading on momentum is not a computerized or mechanical process. This is why human discipline continues to hold so much sway on your degree of success in momentum trading: you must remain stalwart in waiting for your "best" opportunity to enter a position, and agile enough to keep your focus on spotting the next exit signal.
You should never make investing decisions based on what the market is doing, except for now, maybe.
Past experience and reams of studies tell us there is no way to time the market and that we should buy and hold. That said, there are a few exceptions to the rule. With the total United States stock market up nearly 200 percent from the 2009 lows and increasing worries about what some pundits are calling “bubblelike valuations,” there are a few reasons you should think about selling now.
You got lucky.
Did you buy an investment based on what you heard from your brother-in-law or a neighbor at a barbecue? Be honest! Sometimes, we trick ourselves into think that what we heard on CNBC was research instead of entertainment. Then, before we know it, we end up with some investment that’s exceeded just about every expectation. If you did nothing more than hear a tip from a friend or on the TV, that’s luck, not skill.
To use an extreme example people have been talking about lately, let’s say you placed a bet on Fannie Mae at the beginning of 2013. Remember Fannie Mae? It’s the poster child for the mortgage crisis along with Freddie Mac.
Both firms received huge amounts of cash from the government and were written off as dead by the market. In hindsight, it looks obvious: What a great opportunity! But if all you did was think, “Wow, that’s cheap,” with no research, well that’s luck. Lo and behold, Fannie Mae went from $0.30 to about $3. A ten-bagger, in market speak.
If you were lucky enough to buy Fannie Mae, now would be a good time to sell. To be clear, I’m not saying Fannie Mae will go up or down. I don’t know where it’s headed, but the point is, neither do you.
You got lucky, and it’s time to take your money and run.
You don’t know why you own something. Closely related to being lucky is the idea of being a collector of investments instead of an investor. If you don’t pay attention, you can end up with a portfolio suffering from multiple personalities where nothing works together particularly well. Maybe you inherited a bond from a grandparent or bought stock in a company where a friend used to work. Whatever the reasons, you now have a smorgasbord instead of a portfolio.
Chances are that smorgasbord has done well in the last year or two. That doesn’t make it a good portfolio.
Remember that almost every category of stocks has done well, so don’t confuse a rising market with your own personal genius. Now would be a good time to look at selling and using the money to build a portfolio on purpose.
You’re a systematic market timer. This sounds exciting! Like something those famous hedge fund managers claim to do. Before you get too excited, systematic market timing is the fancy way of saying you need to rebalance. If you already have a well-designed portfolio that you’ve built on purpose, what’s happening in the market may mean it’s time to sell.
For instance, your portfolio design may call for 60 percent stocks and 40 percent bonds. But since stocks have done really well in the last year, your portfolio may now be 70 percent stocks, even with the recent decline. So, in that case, you should be selling stocks and buying bonds to get you back to your 60/40 split.
The one caveat I’ll add is that rebalancing is not a daily or even weekly activity. So don’t get carried away. Systematic means just that. It’s selling based on specific criteria and not whenever the mood strikes, and it is going to be dependent on what’s happening in the market. An added benefit? Changing the way you think about boring rebalancing means the next time the cocktail conversation turns to making smart moves in the market, you can proudly proclaim that you’re a systematic market timer.
One caveat here: If you’re thinking about selling now, there’s a big difference between selling out of fear and selling by design. We want to take action based on a principle — like being diversified in the case of a big holding in an individual stock like Fannie Mae — instead of emotion. Otherwise you may find yourself in the awkward position described by Warren Buffett.
While he recognized that a rising tide — or market — covers a multitude of sins, you only find out who is swimming naked when the tide goes out. I’m betting we’d all prefer to be wearing our suits. So if you’re thinking about selling now, make sure it’s for a legitimate reason, not an emotional one.
