Trading Momentum | stockbee

12/21/2007

Trading Momentum

Both Double Trouble (DT) and IBD 200 are essentially momentum systems.

Double Trouble is a single factor or single variable momentum system. It uses just momentum to select trading vehicle. The underlying hypothesis is the current momentum will persist for some time. So we enter a vehicle running at "100 miles per hour" when it has "a slight pause". You are not really looking at the underlying reason for the momentum. The stop manages the risk in case of reversal of momentum. The time stop ensures one does not get stuck in the pause phase for long. Actual implementation of the method is some part strategy, some part tactics and some part artistry. You can think of many ways of trading the basis strategy of playing momentum.

IBD 200 is also a momentum system. But it is multi factor or multi variable momentum system. It uses two momentum variables: price momentum and sector momentum. In addition it uses number of financial variables. If you look at them they are broadly earnings growth, earnings quality, and earnings sustainability. Earnings growth variable is in the form of EPS ranking or EPS growth. Earnings quality is represented by sales growth and longer term earnings growth. Earnings sustainability is represented by margin and ROE. Now these "financial factors" are married with sector momentum and price momentum to arrive at top 200 stocks. The implicit hypothesis is that buy momentum but only in good quality stocks.

Now one can argue the second approach is better than the first and IBD 200 is better than DT. IBD 200 seems more logical. But in reality what happens in markets is sometimes good earnings or growth stocks do well, sometime value stock do well, sometime small caps do well, sometime large caps do well, sometime concept stock with no earnings do well. DT finds a common character amongst all these, that is momentum. Plus because it calculates momentum differently from the IBD approach a turnaround play will be in DT while it might not be in IBD 200 for long time.

Hence a combination approach ensures you do not miss out on major opportunities.

1 comment:

Bill aka NO DooDahs! said...

Lots of thoughts on diversification of strategies in the blogosphere recently. Good stuff.