Now that you have developed a trading system that has a positive edge, the next step is to know which stocks to buy and which stocks to sell (Short). Historically speaking buying (Long) the strongest stocks and shorting/selling the weakest stocks seems to have performed well. This is what we call momentum stocks. So, what exactly are “Momentum Stocks”?
When a stock has been going up for a while, the likelihood of it continuing up is greater than for it to turn around. A stock which is moving up faster than other stocks is likely to continue to move up faster than other stocks. This, in essence, is the momentum effect.
In the academic field, the first influential paper on the subject was published in the 1960’s (Levy, 1967). Since then there have been some interesting studies confirming their findings and building upon it. One such paper by Jagadeesh and Titman (Jegadeesh & Titman, 1993) came up with two alternative theories as to why momentum investing works.
The first theory was that transactions by investors who buy past winners and sell past losers move the prices away from their long-run values temporarily and thereby cause prices to overreach.
The alternative theory was that the market underreacts to information about the short-term prospects of firms but overreacts to information about their long-term prospects.
There has been plenty of debate on the subject and other theories about why winning stocks tend to keep winning. Possible theories include delayed stock price reactions to common factors, something which Jagadeesh and Titman disagree with. There’s of course the positive feedback cycle of how winning stocks get attention and attract further investors. From a purely practical point of view though, you should ask yourself whether it really matters.
If you can show that the momentum effect exists and has produced excess returns in the past, it’s likely that it will continue to do so. Speculating on the underlying reasons can be an interesting pastime, but is it really relevant to your trading?
A crucial point to keep in mind is that the momentum effect will in reality work very differently in a bear market. When we’re experiencing bull markets or just regular old boring market conditions, the momentum effect works fine.
That’s because in normal and good market climates, stocks can move fairly independently from each other. There’s a greater focus on the stocks themselves, and less on the overall market.
In a bear market, there’s typically an abundance of market level factors.
There’s usually something that drives the market declines and that will be the deciding factor for more or less all stocks. It could be the collapse of the tech bubble, a global credit meltdown, sovereign defaults or other major events.
What happens in bear markets is that all stocks start behaving the same. Diversification becomes an illusion and all stocks move up and down on the same days. The momentum effect isn’t very helpful in these kinds of markets.
In order to develop a momentum strategy, you need to identify the universe that you plan to trade in which could be Nifty-50, Nifty-100, Nifty- 200 or F&O stocks just to name a few. For explanatory purposes we take Nifty-50 as our universe.
We could for instance say that for buy we only consider stocks where the 50-day moving average is above the 100-day moving average among Nifty-50 stocks. By doing this the number of stocks gets reduced as it will weed out the weaker stocks.
Next plot a 200-day moving average of stocks where the 50-day moving average is above the 100-day moving average. Divide the current closing price of each of these stocks with their 200-day moving average and convert the same to percentage. Once done then list them in descending order of percentages and your momentum stocks are ready.
Once you have ranked them in descending order, always go ahead with the strongest stocks which are in the top 10 in terms of percentage, so when your defined entry criteria are met for these stocks just enter the stock.
One of the advantages is you know exactly which stock to buy a day in advance rather than not having a plan and trying to chase stocks randomly thereby resulting in loss.
You can deploy the same strategy to find out the weakest stocks and you could short the same. Find out which stocks are trading below the 50-day moving average below the 100-day moving average, next calculate the percentage change from the 200-day moving average, here the percentage will be in negative.
Next, arrange them in ascending order, meaning the one with the highest negative percentage will be at the top of the list followed by the next highest and so on. So now you have your list of weakest stocks to be shortened as and when the entry criteria are met, you enter the trade.
You may also encounter the situation wherein, if you buy the strongest stocks/sell the weakest stocks today, then what happens if other stocks are stronger/weaker next week or a month from now?
For this you have to have a plan for when to replace your stocks with stronger/weaker stocks and under what conditions this is done. So, either you can follow a weekly plan wherein every Friday you run the scan and see if there is any change in the top 10 stocks, if there is then exit the stock which is no more a part of top 10 stock and replace it with the new entrant on Monday. Similarly, you can repeat the same strategy if you are following a monthly rebalancing plan.
Follow the entire series here.
Kirit Manral is a professional trader, and has been running a mentorship program in trading since 2019, with mentees from around the globe. He can be found on Twitter at @KiritManral