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.

043003_chart1small.gif
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.

043003_chart2small.gif
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.

043003_chart3small.gif
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.

Related Articles
  1. Trading Strategies

    Momentum Trading With Discipline

    This type of strategy demands controlled decision-making, requiring a continual refinement of entry and exit techniques.
  2. Active Trading

    3 Technical Tools To Improve Your Trading

    Find out how volume, the Aroon indicator and Fibonacci numbers can improve your profits.
  3. Trading Strategies

    Momentum And The Relative Strength Index

    These two indicators can give the trader a better understanding of when to get in and out of an issue.
  4. Forex Education

    How To Build A Trading Indicator

    Wondering how people like Elliott and Gann built their famous trading tools? Learn the basics of constructing an indicator.
  5. Trading Strategies

    Momentum Indicates Stock Price Strength

    Momentum can be used with other tools to be an effective buy/sell indicator.
  6. Technical Indicators

    Understanding Trend Analysis

    Trend analysis is the use of past performance to predict future price movement of a security.
  7. Trading Strategies

    How To Buy Penny Stocks (While Avoiding Scammers)

    Penny stocks are risky business. If want to trade in them, here's how to preserve your trading capital and even score the occasional winner.
  8. Chart Advisor

    Stocks to Short...When the Dust Settles

    Four short trades to consider, but not quite yet. Let the dust settle and wait for a pullback to resistance for a higher probability trade.
  9. Technical Indicators

    Using Moving Averages To Trade The Volatility Index (VIX)

    VIX moving averages smooth out the natural choppiness of the indicator, letting traders and market timers access reliable sentiment and volatility data.
  10. Chart Advisor

    Traders Step Back to Assess Commodities Damage

    Traders are turning to these exchange-traded notes and exchange-traded funds to analyze key commodities and determine what could be coming next.
RELATED TERMS
  1. Fintech

    Fintech is a portmanteau of financial technology that describes ...
  2. Indicator

    Indicators are statistics used to measure current conditions ...
  3. Intraday Momentum Index (IMI)

    A technical indicator that combines aspects of candlestick analysis ...
  4. Mass Index

    A form of technical analysis that looks at the range between ...
  5. Money Flow Index - MFI

    A momentum indicator that uses a stock’s price and volume to ...
  6. On-Balance Volume (OBV)

    A momentum indicator that uses volume flow to predict changes ...
RELATED FAQS
  1. What assumptions are made when conducting a t-test?

    The common assumptions made when doing a t-test include those regarding the scale of measurement, random sampling, normality ... Read Full Answer >>
  2. How are double exponential moving averages applied in technical analysis?

    Double exponential moving averages (DEMAS) are commonly used in technical analysis like any other moving average indicator ... Read Full Answer >>
  3. How do you know where on the oscillator you should make a purchase or sale?

    Common oscillator readings to consider making a buy or sale are below 20 or above 80, respectively. More aggressive investors ... Read Full Answer >>
  4. What are the alert zones in a Fibonacci retracement?

    The most commonly used Fibonacci retracement alert levels are at 38.2% and 61.8%. A 50% retracement level is also commonly ... Read Full Answer >>
  5. How was the Fibonacci retracement developed for use in finance?

    The use of Fibonacci retracements in stock trading was popularized by noted technical analysts W.D. Gann and R.N. Elliott. ... Read Full Answer >>
  6. How reliable is the Fibonacci retracement in predicting stock behavior?

    The use of the Fibonacci retracement is subjective. There is no objective method to verify one application of the Fibonacci ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!