Use The Momentum Strategy To Your Advantage

By Investopedia Staff AAA

How many times have you decided to invest in an industry and then spent the time, both fundamentally and technically, to research the industry's leading companies, only to get cold feet when the time came to put in your buy order? The momentum strategy has been known to work well to overcome this obstacle.

Strategy Examples
The momentum strategy has a number of examples from which to choose; the novice trader is wise to study as many of these examples as possible to develop a sound footing for future buying programs. Here are a few examples:

With a number of factors in mind, novice traders need to develop a strategy by examining personal tolerance levels with a clear understanding of the trend within the market. Long bull markets will bring out the individuals who are braver than those retail investors, who today are sitting on the sidelines after the better part of a three-year bear market. It is this kind of market that will bring out the best in an investor or trader who is focused on a strategy and has the patience to confirm its readings.

Professional traders often use more than one indicator in their work because no one indicator can provide everything for making that critical decision to buy an issue.

A Case Study
Let's take a look at a number of the above-listed examples of the momentum strategy for examining shares of The Gap (NYSE:GPS).

In the first chart of The Gap, the red arrows are placed at the most obvious buy signals, the first of which occurs on Oct. 22, 2002, with the stock price closing at $9.99. The run-up over the next few weeks takes the stock price to a lofty level of $15.99, a 62% increase. The second arrow sits at Mar. 18, 2003, with the stock price closing at $14.75. The April 30 close is $16.67.

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Chart Created with Tradestation

The second chart (below) shows an increase in the volume-traded daily starting on Oct. 17, 2002, with 3,121,000 shares traded and the stock price closing at $10.52. The volume uptrend continues over the next few weeks to a high of 16,261,000 shares traded on Nov. 7, where the stock price closes at $13.42. This uptrend coincides closely with the crossover of the dual moving averages in the first chart, but the importance of using more than one indicator in any strategy is now clear: the stock price continues to rise on or about March 6 as the downtrend in volume has already begun. Those individuals using only a volume indicator would have been left out on the next run-up in stock price.

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Chart Created with Tradestation

Now, two indicators tell two different stories - which one do we believe and act upon? It is time to enter the third indicator of our momentum strategy, the ADX, to help with the confusion.

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Chart Created with Tradestation

A very straightforward explanation of the ADX is that it measures the strength of a prevailing trend as well as determines whether movement exists in the market. The ADX is measured on a scale of 0 to 100. A low ADX value (generally less than 20) can indicate a non-trending market with low volumes; a cross above 20, on the other hand, may indicate the start of a trend (either up or down). If the ADX is over 40 and begins to fall, it can indicate the slowdown of a current trend. This indicator can also be used to identify non-trending markets or a deterioration of an ongoing trend. Although market direction is important in its calculation, the ADX is not a directional indicator.

Given that explanation, the ADX in our chart of The Gap shows the definite strength of the trend at the end of October. On November 1, the ADX reading is 20.03. With the moving averages first showing the buy signal in our strategy and with the volume increasing at about the same time, the confirmation is clear as our ADX chart rises above 20: traders should have been in on this stock.

However, the confusion over whether or not a buy signal was clear continues in March of this year. On the same date that the dual moving averages shows a very clear buy signal, the ADX is falling at 18.64, having crossed above the 20 mark the previous week. Investors were leaving this stock, which is indicated by the downtrend in volume, and the ADX confirms the trend was breaking down.

The Bottom Line
The importance of momentum strategy is in the understanding of these examples and how it tells us when and where to enter the market. Confirmation is key, and if followed closely, the momentum strategy allows for greater profits, and, more importantly, greater piece of mind.

SEE: Confirming Price Movements With Volume Oscillators.

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