Focus on momentum to develop setup ideas

How does one develop a setup idea?

By focusing on a known and proven tendency of the stocks or markets you can develop setups around it to profit from that tendency.

Momentum is the number one tendency of stocks and has been proven anomaly.

Momentum investing looks for stocks rising faster than the overall market. Or in simple language it looks to buy strength and sell weakness.

Momentum has been extensively studied and studies show that stocks with the best price performance over the previous 3-12 month period tend to continue to outperform the market over the subsequent 3-12 month period while previous losers tend to continue underperforming.

The most celebrated study in the academic literature which documented this phenomenon was by Jegadeesh Narasimhan and Sheridan Titman in a study titled "Returns of buying winners and selling losers"

Jegadeesh, Narasimhan & Titman, Sheridan, 1993. " Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency," Journal of Finance, American Finance Association, vol. 48(1), pages 65-91, March.

This paper documents that strategies that buy stocks that have performed well in the past and sell stocks that have performed poorly in the past generate significant positive returns over three- to twelve-month holding periods. The authors find that the profitability of these strategies are not due to their systematic risk or to delayed stock price reactions to common factors. However, part of the abnormal returns generated in the first year after portfolio formation dissipates in the following two years. A similar pattern of returns around the earnings announcements of past winners and losers is also documented.

Practising traders were aware of this phenomenon for years and were exploiting it .Since then this phenomenon has been studied in detail and it has been shown that this works across markets and is persistent in spite of it being known to market participants for years.

Top Research Papers About Momentum

CHAN, L., N. JEGADEESH and J. LAKONISHOK, 1996. Momentum Strategies. NBER Working Paper. [Cited by 297]
GRINBLATT, M., S. TITMAN and R. WERMERS, 1995. Momentum investment strategies, portfolio performance, and herding: A study of mutual fund behavior. American Economic Review. [Cited by 255]
HONG, H. and J.C. STEIN, 1999. A unified theory of underreaction, momentum trading and overreaction in asset markets. The Journal of Finance. [Cited by 363]
ROUWENHORST, K.G., 1998. International Momentum Strategies. The Journal of Finance. [Cited by 216]
JEGADEESH, N., S. TITMAN and M.P. PAGE, 2001. Profitability of Momentum Strategies: An Evaluation of Alternative Explanations. The Journal of Finance. [Cited by 193]
HONG, H., et al., 2000. Bad news travels slowly: size, analyst coverage, and the profitability of momentum strategies. The Journal of Finance. [Cited by 214]
LEE, C.M.C. and B. SWAMINATHAN, 2000. Price momentum and trading volume. The Journal of Finance.[Cited by 162]
MOSKOWITZ, T.J. and M. GRINBLATT, 1999. Do Industries Explain Momentum?. The Journal of Finance.[Cited by 163]
GRUNDY, B.D. and J.S. MARTIN, 2001. Understanding the nature of the risks and the source of the rewards to momentum investing. Review of Financial Studies. [Cited by 126]
LIEW, J. and M. VASSALOU, 2000. Can book-to-market, size and momentum be risk factors that predict economic growth. Journal of Financial Economics. [Cited by 122]

In simple terms what we know from these various studies is that:

Stocks exhibiting 3-6-12 month momentum are likely to outperform in subsequent 3-6-12 month period.
1 month momentum tends to lead to reversal.
Longer term momentum of 2-3 years also tend to lead to reversal.
Momentum effect is more pronounced for small capitalization stocks.
Studies also show sector momentum works in similar manner to stock momentum.

Besides the academic world actual market practitioners have also studied momentum based strategies and found that momentum based strategies work. In next part we will look at some of these researches.

So your starting point for developing a setup should be to base it on momentum. There are many ways to rank stocks by momentum. Once you rank them by momentum you can look at entry on pullback or consolidation.

Momentum can make you millions once you understand how to exploit it.

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