Why should traders always stay on the right side of momentum?

Stock Market | Published on 18th April 2018 | 42

The legendary trader Jesse Livermore once said that when it comes to trading the market, there is no bull side and bear side. There is only the right side. What Livermore intended to convey was that it is not the job of a trader to judge whether the market will go up or the market will go down. It is also not the job of the trader to predict the levels of the index and try to time the market. The job of a trader is primarily to discern and understand the underlying message of the market and trade accordingly. To that extent, the trader is not required to beat the market or to outsmart the market. As Jesse Livermore often used to day, you really cannot outsmart the market. Therefore trading wisdom lies in identifying what best trades you can put within the confines of the market message.

That is what momentum is all about

Momentum in stock markets, like in physics, refers to the acceleration of a trend. The uptrend or downtrend in the stock price is driven by two key factors. Firstly, there is the momentum that is driven by technical indicators. For example, when the stock price constantly keeps hitting the resistance level and falling down then the pace on the downside could get accelerated. Similarly, if the stock breaks above the resistance with speed and volumes then we could see upside momentum building. A similar analysis can be applied for the support levels of a stock also. When the trader sees either upside momentum or downside momentum building in a stock due to a mix of technical factors, then the trader takes a long or short position accordingly.

Secondly, there is the momentum driven by news-based factors or event-based factors. For example, when the markets are expecting the RBI to cut rates and if the RBI hikes rates instead, then this event could trigger negative momentum on the stock price. This is more so for rate sensitives. We also saw in the aftermath of demonetization in November 2016 when many cash driven sectors like cement, FMCG, construction, realty and NBFCs saw a tremendous build-up of negative momentum. Here again, the trader’s job is to identify the momentum and trade accordingly.

Five rules for momentum traders to remember…

The most important message for the momentum trader is that they should just focus on two points. Firstly, they must focus on how much loss or capital depletion they are willing to accept. They must peg the risk of their trade accordingly. Secondly, they must ensure that they are on the right side of momentum. The important point here is to be driven purely by data and scientifically verifiable evidence. The moment the trader starts using discretion that is when they fail to spot the momentum and get into losing trades. Here are 5 rules that momentum traders must focus on…

Rule1: Momentum must only be tracked on a Watchlist

If you want to make a success of momentum trading then you must have a Watchlist of stocks to focus on. You can decide the total number at 10 or 20 as per your comfort level. Some of the best traders have typically specialized in a handful of stocks only. It is only when you are tracking a small list of stocks that you bring expertise and thoroughness to the job. If you want to find momentum in all the2000 stocks listed on the NSE, then you are never likely to spot anything meaningful. Keep your sphere of analysis limited.

Rule 2: Price and volumes always have a story to tell

This is an important rule traders must adhere to if they want to catch the market momentum. Markets are unpredictable and volumes can be misleading; is all true. But if you keep observing the volumes and price over a consistent period, they rarely give a wrong signal. Of course, there will be noise as is the case with any data stream. But once you have zeroed down your list to about 20 stocks you can very well distinguish between trend and noise.

Rule 3: Technical levels are your milestones for confirming momentum

Be it supports, resistances or the chart breaking above or below the 200 DMA; these are the indications that will confirm your understanding of the momentum of the stock. Of course, you need to put in your checks and balances before taking the trade decision. If you really want to understand how to pick the momentum in a trade, then an in-depth understanding of these key technical indicators is a must.

Rule 4: A momentum trader typically must catch the momentum moments

If that sounds confusing, it is actually quite simple. You do not get big news events like Budgets, monetary policies, trade wars and oil spikes on a daily basis. These events occur once in a while. Then how do you trade momentum on a daily basis. That is where you need to focus on the momentum moments. On normal days, you will find that most of the volumes and the maximum momentum are created either in the first hour of trading or the last hour of trading. That is where traders should ideally focus on to gain maximum leverage from momentum.

Rule 5: You just can’t beat discipline when it comes to momentum trading

Like in any aspect of trading, you need to have discipline if you want to stay on the right side of momentum. You have to be rule driven. You have to evaluate technical indicators and event cues based on a clear set of parameters. You lose out on identifying momentum when your trading becomes more discretionary and less rule-based. That is the kind of discipline you need to maintain. If you can identify momentum on a proven set of parameters and manage risk in a meticulous manner, success will be yours as a trader!