Trading Approach "Momentum"

The House Always Wins if You Come Unprepared

Without question, financial markets are complicated entities. They are home to tens of thousands of independently moving financial instruments that constantly fluctuate in real time according to an unfathomable number of scarcely identifiable variables. Yet, it is possible to trade on the markets—and win. In this section, we explain how.

First of all, like any complicated thing, it is necessary to break it down into parts. In the simplest terms, successful trading is just a function of knowing the right time to buy and the right time to sell. That’s it.

Using a combination of software, market research and good habits, it is certainly possible to stay on the right side of a trade most of the time. The Trading Forest will teach you how to do this.

Momentum Price Series Analysis

Part of our process is based on Momentum Price Series Analysis. The exact definition of this term is not important at this point. All you need to know right now is that this means we begin by looking at the general direction that an instrument is travelling. In short: is it going up or down?

This is an important question to ask because the two major risks any trader faces are:

Selling into a rising market
(“trying to hold back the bull”)

Bull market: prices are going up (think: bull tossing its horns up in the air)

Buying into a falling market
(“trying to stop the bear”)

Bear market: prices are going down (think: bear swiping down with its paw)

Seeing which direction an instrument seems to be heading is just the first phase. After all, anyone can look at a graph and see if it is moving up or down. Therefore, our momentum analysis is run in conjunction with an algorithmic process, and these results are then analysed within a quantitative and technical framework. Following quantitative analysis, we are able to test the ‘temperature’ of an instrument. We will then have a good sense of whether we ought to be buying, holding or selling. Finally, we are able to create a watchlist of potential trades and ultimately decide whether or not to execute an action.

The Trading Forest process breakdown

Complicated Variables

Algorithm

Quantitative Analysis ("Leading Indicators")

Technical Analysis ("Lagging Indicators")

Trade Watchlist & Possible Strategies

Trade Execution

Let’s look more carefully at each phase of the trading process

Preliminary checks: Determining where the instrument is classified within the momentum cycle

Our primary aim is to stick with the momentum cycle of the instrument we are following. Therefore, our starting position is always to identity where in the cycle the instrument is. Once we know whether the instrument is heading up or down, we can incorporate leading and lagging variables to determine if a new upward momentum cycle is set to begin (in which case, we’ll be motivated to buy) or if a new downward momentum cycle is set to begin (in which case we’ll be motivated to sell).

It is important to note that even the most prestigious, stable and high-quality companies can be subject to a downward momentum cycle (something that would normally offer patient investors an ideal buying opportunity).

The length of a momentum cycle can vary massively in time, from just a few weeks, to several months or even years. It is therefore unwise to “second guess” a current momentum cycle unless a set of predetermined leading indicators informs us otherwise.

Equally worth noting is that we are not compelled to buy every time an instrument starts an upward momentum cycle or sell every time an instrument starts a downward momentum cycle.

No trader has infinite capital, meaning that we have to be selective in our trades. This is why determining the current ‘location’ of any instrument within the momentum cycle is just the first step in the trading journey. We must then set about applying a rigorous selection process.

Phase 1

Understanding the beginning of an upward momentum cycle

A stock that is just about to begin an upward momentum cycle is actually still entrenched in a downward cycle.

In The Trading Forest terms, this stock would still be located on the Avoid List as the instrument is heading down. The period in which the instrument switches from a down cycle to an up cycle differs from instrument to instrument.

At The Trading Forest, we apply a set of algorithmic rules to any stock that appears to be switching, but each instrument must be observed individually to determine its own momentum cycle and path.

Furthermore, during this phase, our leading quantitative set variables are scanning the instrument in order to identity any fundamental changes in the price behaviour. Perhaps the stock will switch quickly; perhaps it won’t.

Whatever the case may be, there is no guarantee that any instrument will move away from the Avoid List. Making a trade at this stage would therefore be an error.

Phase 2

Instrument moves to the Buy List

An instrument will move automatically from the Avoid List to the Buy List once a predetermined set of quantitative variables are met.

This allows the trader to research the instrument properly and determine if any unexpected shocks can be expected (fundamental, macro, market etc.).

At this stage, the instrument is placed on a watchlist and buy orders can easily be set at predetermined levels.

However, there is still no guarantee that when an instrument moves from the Avoid List to the Buy List that a decent buying opportunity is presented.

Our process considers a large number of variables and we would only recommend making a trade at this stage if a predetermined set of rules are met.

Phase 3

Progression from Buy List to Positive Momentum

At this stage of its ‘life cycle’, the instrument is starting to attract different types of traders—some of whom might be day/short-term/swing/short-horizon? traders looking to buy and sell assets based on the strength of their recent price action.

Common wisdom states that if there is enough momentum forcing a stock price in a certain direction, then the move in that direction is likely to continue for some time.

*Price action (def): Price action refers to the movement of an instrument’s price over time. Any price movement may represent an opportunity for a trader to buy or sell an asset. Therefore, when a stock price (for example) starts to go up, it might stimulate some traders to immediately purchase more of that stock. This purchasing of more stock might then itself have an influence on the price action of the instrument.

An instrument’s recent price action could also give current holders of that instrument the confidence to add to their current position.

If the instrument continues to increase in value over time, The Trading Forest automatically moves it from the Buy List to Positive Momentum. This is normally also an indication that the instrument is starting to outperform its peers and benchmark. This might be a sign that it is a good time to buy, but not necessarily.

Thermometer vs Thermostat

As individual traders, we don’t have the power to determine the final outcome of the market. We do, however, have the ability to measure the temperature of the market and set out our trading strategy accordingly.

Phase 4

The final phase of the upward momentum cycle

Imagining that the instrument has kept shifting along its upward trajectory, our system will now indicate that it has moved from the Positive Momentum list to the Stay Long list. Essentially, this means that the market is comfortable owning the instrument and will continue to add during phases of price weakness.

At this stage, a sensible trader will invest, ride the trend, and avoid seconding guessing the market. In other words, it would likely be an error to react to minor downward price action and panic sell your holdings. Predicting that the instrument is about to make a sudden downturn while it is on the Stay Long list could result in forfeiting a winning position.

One of the most basic mistakes any investor can make is to “cut their winning trades” and “hold their losing trades”.

A momentum trader, in their purest form, will ride the trend until market indicators show much more clearly that an instrument is turning the corner and heading into a downward momentum cycle.

Phase 5

Beginning of the downward momentum cycle

There comes a point in every upward momentum cycle when the instrument peaks and decisively starts heading downwards again. At this stage, the volatility of the instrument will start to increase and although the instrument will continue to be classified as Stay Long, it will fluctuate between the Stay Long list and the Sell List.

This period is subject to market participants beginning to cash in their profits and reducing their holding positions. Traders will be looking for more attractive opportunities elsewhere and the instrument will therefore start to “perform in-line” with the market after a sustained period of outperformance. This may be a good time to sell, but not necessarily.

Phase 6

Instrument moves to the Sell List

Once a predetermined set of quantitative variables are met, an instrument will move from The Trading Forest’s Stay Long list to the Sell List. This is a sign that the instrument has very likely passed its peak and is on a definite downward trajectory.

This indicates to the trader that they should probably dedicate some time to researching the instrument in more detail to confirm that the market is no longer willing to “own the asset” or have an overweight position above its peers.

At this stage, the instrument is placed on a watchlist and sell orders can be set at predetermined levels.

Phase 7

Progression from Sell List to Negative Momentum

If an instrument’s price action starts to gain some downward momentum, it could be a sign that investors are starting to lose confidence in the instrument by reducing its holding and going underweight. Another crucial diagnostic sign for the trader at this stage is whether the instrument is beginning to underperform in comparison to its peers and the market.

The crucial mistake for the trader to watch out for here is not to buy too early as the “negative momentum process” can last for an extended period of time. Buying too early could mean not getting the best price.

At this stage, it is recommended to exercise caution by asking a simple question: “Why is the market selling this instrument?” or “What are we missing in this price action?”

It is always important to note that if the market is wrong, there will be sufficient time to buy the instrument. Our research has shown, however, that when an instrument moves from the Sell List to Negative Momentum, the negative momentum will continue for an extended period of time.

Phase 8

The final phase of the downward momentum cycle

As an instrument transitions from having Negative Momentum to the Avoid List, it is an indication that the market is not willing to allocate a premium to buying this instrument. Moving from Negative Momentum to the Avoid List could also represent a lack of interest in that particular instrument from the market’s perspective.

As an instrument approaches the final phase of a downward momentum cycle, the trader has the following options…

SUMMARY

Correct time to buy an instrument

If you do not own any stock, you must begin by looking for buying opportunities. At a glance, this can be overwhelming, but using The Trading Forest, these opportunities will be clearly indicated to you when an instrument moves from the Avoid List to the Buy List.
When to add to your position

If you already own stock, you will either be looking to hold on to it, add to it, or sell it. Using The Trading Forest, you will have a very strong indication of when to add to your position by seeing when the instrument moves from the Buy List to Positive Momentum.
When to hold your position

Depending on your appetite and resources, you might choose to keep adding to your stock as it has Positive Momentum, or simply to keep riding the momentum of its upward trajectory. It is advisable to continue holding the instrument at least until a predetermined set of technical variables are met, or when the instrument moves from the Stay Long List to the Sell List.
When not to buy

Whether or not you already own stock in an instrument, if there is negative momentum present, we highly recommend you do not buy. At this stage, the instrument is classified on the Sell List or Negative Momentum List. Always remember to ask yourself: “is there further downside?” If the answer might be yes, then buying at this stage could result in losing money.
Correct time to sell an instrument

When an instrument moves from the Stay Long list to the Sell List, this is the right time to look for selling opportunities. Trading and managing a profitable position requires a considerable degree of mental fortitude–and risk management is crucial when managing a new position. In order to know the optimal time to sell, it is crucial to follow a predetermined set of rules and guidelines. Doing this limits the risk of being gung-ho and making emotional decisions that could affect your profits.
When to add to your sell position or reduce your current holding

Negative momentum is prevalent when the instrument has moved from the Sell List to Negative Momentum. Once this takes place, there is no need to second guess the market. The correct action to take at this stage is to bank your remaining profit—or add to your Short Position.
When not to sell

Our approach is also not to sell when a negative price action has run its course. At this stage, the instrument has now moved to the Avoid List. Selling now will return the lowest profits for your position and the bitter pill to swallow is that you should have sold much sooner, when the price was higher. The length of time that an instrument stays on the Avoid List is unpredictable, but the downside damage will already have been done when the instrument is classified as ‘avoid’.