WALL STREET SMARTS, THE BLOG, IS NOW WALL STREET SMARTS, THE BOOK. FULLY EDITED AND REVISED WITH NEW MATERIAL ON AMAZON
There is a significant amount of scientific research and literature dealing with birds of prey, such as eagles, hawks and falcons, and how they hunt. The raptors' vision far exceeds that of humans. The bird perches in a tree or other elevated location and searches the surrounding area (up to a mile away) for small mammals. What attracts the bird's attention is movement. This explains why rabbits can remain still for such long periods of time. Movement attracts the hunter's attention. The same thing holds true for momentum traders.
Momentum trading is based on two concepts.
The first is that investors are slow to react to news about a company or its stock. Unexpected price announcements or other surprising company news (whether good or bad) may trigger a move in the company's stock which will continue for a period of time after the announcement as investors analyze the news and decide how to react. The momentum trader looks to quickly jump into the stock early in the move and sell out of the stock with a profit shortly thereafter. Momentum trading based on announcements has a time horizon measured in hours or, at most, a day or two. Because the stock movement is usually small, in relative terms, many momentum traders use margin (borrowed money) to increase the amount of profit he or she hopes to gain.
The second basis for momentum trading is the old rule, "The trend is your friend." The trader looks for stocks with a large degree of "relative strength." The trader may compare the stock's current velocity of price change to its average rate of change over the past few months. If the stock has been moving in a direction at a price change rate of $1 per week and is now trading at a rate of $5 per week, it would look like a candidate for a momentum trade. It is also possible to compare a stock's rate of price change to the average rate for other stocks in its industry or in the overall market. Similarly, the momentum trader may look for stocks with unusually high trading volume. A stock which normally trades 10,000 shares a day and is now trading 100,000 shares a day will attract the attention of the momentum trader. These traders may also look for a chart indicator showing a point of inflection, i.e., the point at which the stock's trading trend will reverse. Large volumes following such a change of direction would be attractive to momentum traders. As we learned in an earlier blog, this point of inflection is best demonstrated by the head and shoulders technical indicator.
Successful momentum traders have two characteristics. First, they must have the time to devote to the constant monitoring of his or her stock positions throughout the day. Second, they must be ready to trade out of a stock at a loss very quickly if the movement is going against them. The big profit on one trade is supposed to make up for the small losses of other trades. Momentum trading, therefore, is a strategy for professionals who are in the market on a daily basis and are willing to suffer any number of small losses as a "cost of doing business." It is not a strategy for the "part time" amateur. If you are interested in learning more about momentum trading, here is a link to an in depth article about it. I suspect there may be mutual funds using momentum trading as their primary strategy.
In the next blog we will learn about one of the most famous of these traders, Jesse L. Livermore, who made and lost millions on Wall Street during the early decades of the twentieth century.
Comments are always welcome.
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