Some traders watch a stock take off then chase it like the crazed neighborhood chihuahua who barks after anything that passes in front of its yard. It may be funny when the chihuahua yaps after dogs many times its size, but the lesson for traders should be clear: risk control must be paramount.
Like the chihuahua, traders who chase every move often enter too late or exit too early. Worse, chasing the wrong setups in the wrong markets often results in small profits, large losses and frustration. Traders who approach markets without using key fundamentals will find themselves in this situation often.
The momentum wave concept can help you with this risk control and give you key fundamental lessons when developing your own trade setups or understanding the inner mechanics of a trading method. By recognizing and implementing this concept, you can begin applying it to your current trading. Included in this concept are a few key principles that when integrated into a sound trading method can help improve your trading. They are the principles of momentum, velocity and compounding.
THE BIG MO’
The principle of momentum in trading relates to the acceleration of a stock’s price action in a given direction combined with return on investment (ROI).
When trading and applying the principle of momentum, try to picture waves coming in and out at a beach. There are large numbers of surfers that swim out to the rough looking to experience the bliss of the perfect run on a great wave.
Now, imagine that you’re a surfer at this beach who is patiently sitting on his surfboard in the rough watching all the other surfers attempt to ride anything, only to end up floundering in the water or experiencing the thrill of a short run on a mediocre wave.
Suddenly, something subtle catches your eye. You position yourself on your surfboard when a wave forms and you’re in the perfect spot to exploit it. You don’t need to make any effort to gain entry on this wave. Simply let it take you along for the ride.
The wave builds strength and momentum. Its power is awesome, and yet you are gliding gracefully in the thick of the wave’s intense rush and effortlessly adjust your position on the surfboard under your feet while exploiting the wave’s powerful move.
Suddenly, you ride the powerful currents of the wave to the top of the crest just as the wave begins to grow ever stronger, ever larger. Many of the other surfers try to latch on to the wave to ride its power but many are too late and others only get in to partially ride the wave without ever enjoying the full move. The great wave surges forward one more time, attracting even more surfers who try to enter the move to enjoy the ride.
With that great surge in the wave’s movement, you now sense that the move is coming to an end and begin to slide off the wave’s back. Others foolishly believe the wave will go on forever, forgetting that there is a beach ahead. This wave’s progress, like all things, must come to an end.
Similarly, in trading, you observe charts of stocks that have statistically based criteria for taking off in a bull run (higher than average earnings, increased volume, earnings pre-announcements, etc.) and watch the price action for stocks that are setting up. You begin to look for certain traits in the charts, such as gaps in price, laps in price action and bullish price bars that are two to three times the normal average range while closing toward the uptrend. When you spot these distinctions in the stock’s price action and all this criteria coming together, you realize that a bull run is beginning.
You prepare by placing a buy order in front of the stock’s price action. If the stock takes off, you should put yourself into a position so that you can move along with it.
If it does take off and you latch onto the move, then you simply adjust your position as the stock advances. If momentum begins to fade off, which causes the stock’s price to fall back, then you adjust for it with trailing stops, so that the decreased momentum simply takes you out as it fades away.
CONTRACTION & EXPANSION
While looking for the next momentum wave setup, you’ll observe two primary types of price action in the market: contraction and expansion.
When markets are contracting, it is typically within a given range, and this is obvious from the price action on a chart. Price will typically fluctuate between two price points or within a certain range.
Expansion is when price breaks out of a given price range and accelerates to new highs or lows like a wave forming in the rough that forms and gains strength. It is in this accelerated move where momentum becomes apparent. Now, the principle of momentum can be measured in relation to how fast the stock accelerates along with how much potential it shows (see “Expanding opportunity” ).
While these explosive periods of expansion in the stock’s price action reveal a measurement of momentum, its effects are multiplied by using the principle of velocity.
The principle of velocity gives you a model to magnify the effects of momentum. You can take advantage of velocity by selecting the right markets to trade that are coming out of contraction and moving into expansion, capturing part of the move, taking profits, and then repeating this process over and over again, while measuring the speed at which you can do it. Trade, profit, cash out, and then repeat where appropriate. This allows you to turn over your capital to maximum advantage by getting the greatest ROI as quickly as possible.
You then can utilize the law of compounding in your trading by reinvesting your trading profits. The exponential effects of reinvesting your capital by utilizing the principles of momentum and velocity allow you to use what Albert Einstein called the “most powerful force in the universe.”
By repeatedly redeploying your capital along with your profits, you gain the advantage of squeezing out more gains that build exponentially upon
each other.
All trading approaches to the markets are designed to exploit an edge over the markets and against other traders. By using a sound trading method along with these principles and key fundamentals, you now have a huge edge that is further magnified with synergy that all these principles have in working together. You just have to be aware of them and identify the key leverage points in your trading approach to know where to
apply them.
For example, if you have a trade setup for trading efficient markets that leaves you on the sidelines until the next trade setup, then perhaps you can add a setup to exploit this velocity while waiting for the primary setup. You can incorporate it into your trading plan or find a brokerage that will pay you a higher interest rate while you are sitting in cash. This way, you are always using the principle of velocity in your trading approach.
By utilizing the principle of momentum, the principle of velocity and the law of compounding and integrating it with the momentum wave concept, you gain a big edge in your trading that can be exploited over and over again. By identifying the key points in your trading that you can gain greater leverage on, you can increase your gains while reducing your overall risk.
Billy Williams is a 20-year veteran trader specializing in momentum trading in both stocks and options. Read his market commentary at www.StockOptionSystem.com.