A Lesson in Momentum Trading

Mar.28.10 | About: True Religion (TRLG)

I get quite a few questions these days regarding my trading philosophy, strategy, and tactics. I want to review a chart I came across that really gets to the heart of my style, how I think about individual trades, and trading in general.

I run two different strategies for clients of Surfview Capital. The long/short strategy is a blend between a donchian channel momentum system with an intermediate term time horizon, and a short term trading strategy which takes very concentrated positions on the 1-3 day time frame. The second, the one which I speak about more often on this blog, is the momentum strategy, which takes only long positions on the 1 week to 6 month time frame. Today, I’d like to speak a little bit about how I execute the momentum strategy, what I’m looking for in the positions I take, and how you can use this strategy in your own trading.

It should be obvious to you by now that I am not a value investor. In my long/short strategy I could really care less what a company does, what it’s worth, how profitable it is, what its growth prospects are, it just doesn’t matter. Trading on shorter term time frames, or in the case of the donchain channel system which trades indices and commodities, fundamentals matter not. But in my momentum strategy, fundamentals come into play, as I am looking to buy equities which I can hold for weeks to months.

What type of fundamentals you ask? Well mostly earnings and revenue growth; I’m not looking to buy undervalued stocks. But I am looking to buy stocks that I believe the market is unfairly pricing, which have the ability to see rapid price appreciation, and rapid P/E expansion. Take for instance a long position I currently hold in True Religion (TRLG). The company is trading at a 15 P/E with earnings and revenue growing at at a double digit pace quarter over quarter. There is a 40% short position in the stock from fundamental investors who obviously do not believe in the story. I’ve done my homework on this stock, I’ve been to the store, I’ve gone through the web site, I’ve talked to friends, other traders and investors and come to the conclusion that the market is obviously not respecting this company’s growth potential. And as a result of my research, the stock goes on to one of my watch lists where I wait for the technical picture to set up.

Buying a stock just because it’s cheap on some value screen has never made any sense to me. There is always a reason why a stock is moving in a certain direction, or no direction at all, over the course of 4-6 months. On the 1 week time frame a stock can move any which way for no reason at all, but 4-6 months makes a trend, and on that time frame the fundamental players who are throwing around big money are moving a stock.

If a stock is trapped in a downtrend for more than 3 months, there is obviously something wrong with the fundamental picture of that company to the point where investors are either dumping their positions, or throwing on short positions to take advantage of what they see as a company in decline. To buy a stock in a downtrend like this because it looks “cheap” is a fools errand in my mind and should only be left to the bravest and smartest amongst us.

Bill Miller has made a living for decades off of this strategy, he has balls the size of balloons, but even he got wiped out in the 2008 crash which erased any outperformance his fund had seen over the past few decades, not to mention his horrendous absolute return over that time.

If you believe a stock is cheap, wait for the technicals to set up. I’m going to go through the chart of an unnamed stock right now to show you what I look for when trading my momentum strategy.

Follow along as I highlight aspects of the chart which correspond with the numbers and arrows (click to enlarge).

After experiencing a vicious downtrend this stock began to set up in late March. Notice now it had run up into resistance from late January and was squeezing into a wedge above the rising 20 day moving average. At arrow number 1, the stock broke out of its consolidation, above the red downtrend line and closed strong. A strong close on a breakout from this pattern is extremely important. It is at the close of this day when you want to take your initial position. Set your stop below that day’s low. The next few days showed consolidation of the breakout and gave another chance to get in to this stock if you hadn’t previously. It also gave an opportunity to increase your position size.

The stock ran hard the next few days after which some profits should have been taken. After a move like this I would normally sell about 1/3 of my position. The move was followed by about two and a half weeks of consolidation in a beautiful bull flag.

You want to see low volume on this consolidation and tight price action as seen here (click to enlarge). Wild swings in the flag are red flags. As the stock approaches the 20 day moving average in purple, you should be looking to increase your position size. At arrow number 2, the stock breaks its red downtrend line and closes strong, this is where you want to increase your position and set a new stop below the 20 day moving average.

The stock surged on strong volume closing at the top of its range, another god sign that this is just the beginning to a longer trend. At this point you should realize that the 20 day moving average is an important market for this asset. Some assets react to different moving averages, some not at all. You must look for clues as to which moving average the stock reacts to in its price action. At arrow number 3 the stock comes down to touch the 20 day moving average intra day but bounces strongly and closes nearly positive in what we call a hammer candle. This should have been another tip that the 20 day moving average was important and the trend was not yet over.

The stock spend a few weeks consolidating in a tight range followed by arrow number 4 which shows another breakout on strong volume. This breakout though was given back, unlike the others, which should have been a red flag that the trend was beginning to tire. Notice also that the stock did not close near its highs on the breakout day. It was followed by another wedge consolidation above the rising 20 day moving average and the stock had yet to give any reason to sell.

At arrow number 5 the stock breaks above its red downtrend line on large volume and closes strong. It puts in another couple of strong days after which a similar 1/3 position should be sold. It is now that you should have drawn the green uptrend line shown on the chart. In order to draw a trend line of this sort, three points are needed. The stock then puts in a falling wedge pattern and find support again at the 20 day moving average, it has not since the initial breakout closed below that 20 day moving average.

A further run above $18 takes place followed by a test of the green uptrend line. The next day shows a large volume sell off which breaks the line as well as puts in the first close below the 20 day moving average. Bells should be going off it your head at this point that the trend is in jeopardy. Now, exiting your position in a stock that has shown your tremendous gains as this one did can be extremely hard. I struggle with this all the time. You feel a sense of attachment the stock, the feeling that it will show you love in the future as it has in the past. I would not fault the trader who did not sell on that huge volume break of the uptrend.

The stock ran along the flat 20 day moving average for a few weeks followed by a test of the 50 day moving average which produced a strong bounce. If you were still in, your stop should now be placed below that 50 day moving average. And at arrow number 7 the stock produced a large volume down day which broke the 50 day moving average and closed very weak. You should have now stopped out of this position entirely, the momentum is gone.

Five months later this stock had gone nowhere after chopping around, it was dead money, the trend was over.

I hope this gives you a little insight into how I see individual trades. Remember that moving averages and trend lines are not to be seen as systems, they are psychological areas where you should be looking for support and resistance. They are also guides as to the acceleration or deceleration of a trend.

Trade ‘em well.