April 27 (Lagos) - Equity investors are advised to remain invested for a reasonably long term to ensure that they get good returns. This is because the risk inherent in equities is reduced over time and the possibility of earning higher returns increases. However, some people are not comfortable with staying invested for a long period.They prefer to book profits at regular intervals and move on to the next hot stock, a highly risky but potentially rewarding game. This is called momentum investing.
Momentum investing involves buying and selling stocks that are likely to witness a substantial jump in prices in a short span of time. As a momentum investor, one seeks to identify stocks that have the potential to yield spectacular returns within a short to medium holding period, say, 1-6 months.When the market rallies, momentum stocks are usually better placed to lead the market and touch new highs. Typically, the strategy involves capitalising on an existing trend. So, one would try to lock in gains by riding hot stocks, those that are already witnessing a surge in prices, or momentum.
Momentum investing can be rewarding if you can master the use of the indicators available. The strategy can work both ways—you can ride the bull markets as well as benefit from market declines. Hence, to succeed at momentum investing, traders must understand the risks and rewards of each trade. They must not only know how to spot good short-term opportunities, but also how to protect themselves. In this article, we'll examine the basics of spotting good short-term trades and how to profit from them.
Picking The Right Stock
Recognizing the "right" trade will mean that you know the difference between a good potential situation and ones to avoid.
A moving average is the average price of a stock over a specific period of time. The most common time frames are 15, 20, 30, 50, 100 and 200 days. The overall idea is to show whether a stock is trending upward or downward. Generally, a good candidate will have a moving average that is sloping upward. If you are looking for a good stock to short, you generally want to find one with a moving average that is flattening out or declining.
Generally, the markets trade in cycles, which makes it important to watch the calendar at particular times. Since 1950, most of the stock markets gains have occurred in the November to April time frame, while during the May to October period, the averages have been relatively static. Cycles can be used to traders' advantage to determine good times to enter into long or short positions.
If the trend is negative, you might consider shorting and do very little buying. If the trend is positive, you may want to consider buying with very little shorting. When the overall market trend is against you, the odds of having a successful trade drop.
For those keen on making money from this strategy, there are several indicators or tools that can help identify momentum stocks.Likewise, the speed at which a stock is moving up or down will reduce before the final turnaround. The momentum indicators help you capture this reduction in speed. However, a stock that is losing momentum need not necessarily result in a turnaround.
Controlling risk is one of the most important aspects of trading successfully. Short-term trading involves risk, so it is essential to minimize risk and maximize return. This requires the use of sell stops or buy stops as protection from market reversals. Both of these are designed to limit your downside. As a general rule in short-term trading, you want to set your sell stop or buy stop within 10%-15% of where you bought the stock or initiated the short.
Using the right indicators
Rate of Change ( RoC) or Stochastic Oscillator - The rate of change (RoC) indicator is a basic momentum oscillator, which measures the speed at which the stock price is changing within a defined time period. It calculates the percentage change between the most recent stock price and the price that existed ‘n' periods ago. When plotted as a trendline, it forms an oscillator that fluctuates above and below the zero line as the RoC moves from positive to negative. A value greater than zero indicates an increase in upward momentum (spike in RoC reflects a sharp uptick in price) and a value less than zero suggests an increase in downward pressure (plunge in RoC reflects a sharp fall in price). However, this indicator can be misleading if used in isolation. It should be used in combination with other momentum indicators.
Another indicator to be considered is the trading activity around the stock, which is represented by its trading volume. The stocks that are adequately supported by strong volumes can be assured of continued interest, at least in the near term. Low trading volumes, on the other hand, indicate lack of interest in the security and, therefore, a lack of momentum. Usually, momentum investors prefer to buy stocks that are rising with high volume
Relative strength index
The RSI compares the magnitude of recent gains to recent losses. It is calculated by using the formula, RSI=100-100/(1+RS), where RS is the average price for ‘x' days when the stock closes up divided by the average price of ‘x' days when it closes down. RSI ranges from 0 to 100 and a stock is considered to be overbought when this value is above 70, and oversold when it is below 30. However, these are not considered as buy or sell signals because the stock may continue to move, taking the RSI to much higher/lower levels.
Like other indicators, a signal is generated when a stock loses its momentum and turns around. In this case, RSI crossing the 70 mark from above is considered a a sell signal and crossing the 30 mark from below is considered a buy signal.
The moving average convergence divergence (MACD) indicator is used to confirm the buy or sell signals for a particular stock, as given by other indicators, such as relative strength. It shows the relationship between two moving averages of stock prices (usually the 26-day and 12-day moving averages). The MACD indicator comprises two lines. The first depicts the movement that is the difference between the two moving averages, while the other is the signal line (usually the 9-day moving average of the MACD), which is plotted on top of the first line, functioning as the trigger for buy and sell signals. When the MACD falls below the signal line, it is a bearish signal, which indicates that it may be time to sell.
Traders employ indicators like the MACD, RSI, etc, to identify divergence between the stock price movement and the respective indicator. For example, if a stock touches a new high, but the MACD fails to do so (that is, the recent MACD high is lower than the previous high), it is called negative divergence.
This shows that the buying momentum has slowed down in the counter and, therefore, the uptrend in the stock price may be coming to an end. Likewise, positive divergence occurs when a stock makes a new low, but its MACD fails to make one. This implies that selling pressure has receded and that the downtrend in the counter may not continue for long.
Another tool that can help you find good short-term trading opportunities are patterns in stock charts. Patterns can develop over several days, months or years. While no two patterns are the same, they can be used to predict price movements.
Several important patterns to watch for include:
Head and shoulders: The head and shoulders, considered one of the most reliable patterns, is a reversal pattern often seen when a stock is topping out.
Triangles: A triangle is formed when the range between a stock's highs and lows narrows. This pattern often occurs when prices are bottoming or topping out. As prices narrow, this signifies the stock could break out to the upside or downside in a violent fashion.
Double Tops: A double top occurs when prices rise to a certain point on heavy volume, retreat and then retest that point on decreased volume. This pattern signals the stock may be headed lower.
Double bottoms: A double bottom is the reverse of a double top. Prices will fall to a certain point on heavy volume and then rise before falling back to the original level on lower volume. Unable to break the low point, this pattern signals the stock may be headed higher.
Basically the goal of any trading strategy is keeping losses at a minimum and profits at a maximum, and this is no different for short-term trading by educating yourself about the success tools and thereby making wise decisions.