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Stock Trading Strategy: Momentum Trading

Momentum trading is probably the most mainstream of all swing trading strategies. This is because it works best during bull markets, and history is riddled with longer durations of bull markets than bear. It's also the easiest to execute and pivot points are the easiest to identify visually.

Momentum is built on the concept of magnitude-duration. What do I mean by magnitude-duration? In theory, stocks have limited supply (number of shares outstanding) but the demand can be infinite (no telling how many investors would want to buy the stock). So the natural tendency of stocks is to go up, but at a certain angle or pace of ascent (see the black line that slopes upward in the image below).


On the other hand, the natural tendency of investors is to be irrational, as we can't help but be human. So there are many times that people bid up the prices of stocks ahead of the natural angle/pace of ascent. Cliche as it sounds, let us call these instances "irrational exuberance" or "magnitude"(green arrows). When excesses like these occur, it is but natural that these excesses need to be corrected. Thus stocks either move sideways or downwards in time, until it meets up with its natural pace of ascent. Stocks therefore "revert to their means" and do this through time, thus we call this "duration". So long as the trend of the stock (whether up or down) is intact, it will follow this "staircase" pattern of up then sideways/down, then up again or vice versa.

So how does this concept of magnitude-duration relate with the strategy called momentum trading? In momentum trading, you avoid being in a stock while it is in duration mode (correcting or going sideways), while you want to be in a stock while it is making its magnitude (trending). Thus in the image above, you want to be in the stock during the green arrows, and out during the red arrows. This is why traders always beat buy and hold investors. Its easier to go in and out of a stock four times in a year and make just 5% each time for an annual return of 21.6%, compared to buying and holding a stock that goes up 20% with a lot of stomach-churning swings in between. You get less sleepless nights as you only hold a stock when it is moving. When a stock is going sideways or down, you would still have to question if your decision to buy the stock is correct. Also, you can use the freed up cash to trade other stocks that are currently moving. With momentum trading, you only need very little capital to make money since you are always making efficient use of your money.

So what are the rules in momentum trading? Let us go through them one by one:
1) Identify the stock's trend. If you wanna go short it has to be on a downtrend, while if you wanna go long it has to be on an uptrend. How do you identify the trend? Either you draw trendlines or you use the moving averages. For going long, I make sure that the stock is above the 65-day moving average at the minimum (except for a cup and handle formation, which sometimes corrects to the 130-day moving average. All other area patterns follow the 65-day moving average rule). For going short, I want it to be below the 260-day moving average.
2) Identify if the stock is doing its magnitude or its duration. If you are used to it, you can do this visually on the price graph itself (you can see the "staircase" pattern). But the easier way to do it is just by looking at the MACD. If it is way above (or below) zero line, it is doing its magnitude. If the MACD starts to dip (crossover) from this level and starts retreating towards the zero line, then the stock has entered duration. As an example, look at AAPL in the chart below. The green circles are magnitude, the red circles are duration. Notice how the MACD movement coincides with the stock movements.

3) Now to go long (short), focus on stocks that are on an uptrend (downtrend) and are in duration, and identify the area pattern and support/resistance levels. For a more complete tutorial on area patterns, go to StockCharts.com's Chart School.
4) The next thing to do is to wait for the stock to finish its duration and resume its trend, either up or down. Once you identify that it is resuming its trend, you get in (or short) the stock. So how do you know it has finished its duration? This is where the concept of five point reversal comes in. Whatever the area pattern this rule applies. Five point reversal means that the area pattern has completed five legs. The legs are down (one), up (two), down (three), up (four) and sideways/small down (five). This up and down legs are part of the larger area pattern, and are needed to take out excess supply. Sometimes you will see stocks end with three legs, then break out of resistance. You can also buy these stocks but with caution, as these stocks tend to fall back into the area pattern as the supply hasn't been taken out properly (missing two legs). The images below illustrate the five point reversal for a rectangle and a symmetrical triangle.

5) All you have to do now is wait for the stock to go above the resistance levels that you identified with the area pattern, and buy on the break above the resistance levels.
6) Put your stop loss at the low of the small pattern formed by leg 5.

For the AAPL chart presented above, you can see that with a momentum trading strategy, you can enter and exit the stock four times in a span of only 6 months, and getting you to safety when the stock loses its momentum and goes sideways or down (you can use your money to trade other stocks that are moving).

In Part 2 and Part 3 of our Momentum Trading Tutorial, we will feature how to trade flags and continuations (using the ADX and DMI lines).

For the meantime, here are the other tutorials we have already provided:
How To Develop Your Stock Trading Strategy, Pt. 1
How To Develop Your Stock Trading Strategy, Pt. 2
Stock Trading Strategy: Buying Pullbacks
Stock Trading Strategy: Support/Resistance or Range Trading
Stock Trading Position Sizing
How To Set Stop Losses