Last week we looked at how research shows that momentum is the most persistent tendency in the market. See my post How to Make Money Using Momentum for more details on it.
As a trader on a practical level you need to translate that momentum research in to trading profits. That is where the rubber meets the road. How can you design ways to exploit the momentum effect. For that you need to study different approaches used by traders. Over next series of posts I will highlight some of the ways traders use momentum to extract profit from the market.
Mark Boucher in his book details his Momentum/ Relative Strength based system for trading the world markets, the commodities, and the stocks. At the heart of his equity selection method is momentum. He use a weighted average Rate of Change or ROC to rank stocks. He offers two methods for equity selection based on whether you are long term traders or short term traders.
For Long Term Traders
( (2 * C * 100 / C5) + (2 * C * 100 / C25) + (2 * C * 100 / C40) + (2 * C * 100 / C65) + (C * 100 / C130) + (C * 100 / C195) + (C * 100 / C260)) / 11He advises taking top 20% stocks ranked by this kind of ROC scan.
For Short Term Traders
( (2 * C * 100 / C5) + (2 * C * 100 / C25) + ( C * 100 / C40) ) / 5He advises focusing on top 20% stocks by this kind of ROC scan.
After first using relative strength to narrow the universe of stocks, he uses earnings and other fundamental criteria to narrow this universe. Within that narrower universe he uses a Runaway Pattern criteria "TBBLBG" , which stands for Thrust Breakout (TB), Breakaway Lap (BL), and Breakaway Gap (BG).
Thrust Breakout (TB): The low of the Breakout Bar is higher than the low, but below the close of the preceding bar.
Breakaway Lap (BL): The low of the Breakout Bar is higher than the close, but below the high the preceding bar.
Breakaway Gap (BG): The low of the Breakout Bar is higher than the high of the preceding bar.
The selected stock must have five or more Runaway patterns(TBBLBG) in a 21-day period. After that he enters on a breakout from 20 day or more consolidation.
So in summary he uses a momentum based criteria as primary criteria for equity selection and uses fundamentals and technical patterns as secondary criteria to further narrow down the trading opportunities.