Wednesday, January 9, 2013

The true meaning of momentum trading

Many investors have a negative view of momentum trading.  To these skeptics, momentum trading can be lumped in the same category as trend trading, i.e. seeking out stocks in a rising trend and simply jumping on board hoping to catch a ride.  Such an approach is indeed worthy of contempt, yet this isn’t what momentum trading is truly all about.

When done correctly, momentum trading combines the elements of a stock’s price, internal breadth and even earnings.  I believe true momentum trading can be distilled into four basic principles.  In sum, momentum traders seek to discover:

1.    A company whose stock’s price is showing relative strength to the S&P 500 and leadership within its own industry group.
2.    A stock whose industry group is currently experiencing strong internal momentum (defined as the rate of change in the net number of new quarterly, or yearly, highs within the group).
3.    A stock which has strong forward earnings and revenue growth prospects.
4.    A stock which is already enjoys an element of forward price momentum.

Amateur momentum traders would most likely look only at point #4 for identifying trades.  An experienced pro on the other hand would review all four principles before making a trade.

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