Why momentum is now part of my journey - part 2

In last week’s article which you can read here. I discussed the reasons why I have incorporated momentum as a part of my broader investment strategy moving forward.

This week, I explore the methodology I have come up with.

Author Note: Whilst this piece is purely for the purposes of education, it is not intended to be a full exploration of the field of momentum or technical analysis. As with most fields of study and investment lore, there are many different concepts to be covered which are beyond the scope (and word count) of this article.

Stockopedia has a great resource written previously which is extensive in its education on all things technical analysis. You can read it here.

Rather, I am purely compiling this article for the benefit of those interested in the methods I personally have come to employ and my thinking around it. I hope that it can help in an investor’s own exploration journey.

There is also a good resource in Stockopedia which covers specific indicators and contains a lot more formal education. If you are interested, be sure to read it here.

There are a lot of indicators to choose from

Curated over a century of studies, much predating the age of computers, the study of technical analysis has seen many exponents develop a range of indicators to help improve the odds of getting on a stock’s right side.

Technical analysis is believed to have its origins in the 17th century. With examples of Dutch merchants using it in markets, through to Fishmongers in Japan using it to monitor the price of fish on the docks. Therefore, its not just the modern investor who has been fixated with the movements in prices. It has been going for as long as markets have allowed the buying and selling of goods and investments.

J W Wilder, WD Gann, R N Elliot, S Weinstein, R Wyckoff and hundreds (if not thousands) of other protagonists have attempted to find ways to help better predict price movements and get the numbers working in their favour.

So, this was my immediate challenge, how does one cover the breadth of such a body of work, when all I really wanted to do was make sure I knew when to step aside when things got rocky, and when to jump on when the train was pulling out of the station.

What I decided on doing next was to identify my objectives first, and then find the right strategies and indicators that would suit. My objectives were as follows:

1. Know how to identify when a price is going up or down

2. Identify key points on a chart where things might happen

3. Identify when there is a change in the trend

4. Identify when exactly to pull the trigger and do it consistently. Not just for selling, but buying as well.

Down to basics – getting down with Dow theory

Look at the logo below.

It’s the logomark for Stockopedia.

Why is the logo instantly recognisable with investing? (Hint: this is NOT a trick question)

You know it looks like a price chart because hopefully you have seen your stocks go in a similar direction.

But hang on… this image doesn’t have any grid lines, no arrows, there are no axes meeting at an origin, nor are there any prices on the image. Even the colours in this image are not synonymous with investing.

So why is it when we look at it, we instantly conjure up the thought of a share price graph?

It all comes down to the zig and the zag

Our subconscious identifies this as a chart because we see zigs and zags in the image.

For those of a certain vintage, just to be clear, I am not talking about the famous clowns from my hometown of Melbourne. I am referring to the pivot points along the line which have it moving in a general direction North-East.

For those of us who have looked at more than 5 price charts in their entire lifetime (I assume most of you have) we will know that prices very rarely, if ever, move in a straight line in either a north-easterly or south-easterly direction.

We know a price ‘zigs and zags’ on its journey to its ultimate destination.

My first principle - Use Dow Theory

What does the Dow have to do with trends? Nothing ,except the key person who formulated both.

Dow theory was derived from a series of editorials in The Wall Street Journal written by Charles H. Dow, who was actually a journalist, founder and first editor of The Wall Street Journal and co-founder of Dow Jones and Company (hence the connection as they were the creators of the Dow Jones Industrial Average.)

Not only is it one of the first formal teachings on the subject of technical analysis, but it had two key elements for me 1. It was relatively simple to get a grasp of 2. It answered some of my burning questions - 1,2 & 3

In 1922 he completed his book, "The stock market barometer". Without boring you all to snores (though I encourage you to get across the content) there were 6 tenements that Charles Dow applied to investing. As with most things we take away from learnings, the main points that I took away were:

1. History repeats itself.

2. There are 3 types of trends. Uptrend, Downtrend and sideways trend

1. History repeats itself.

I have lost count on the number of times I have reminded investors that past performance is not an indicator of future performance. And I still believe this to be 100% true. However, as with all things, this tenement is a little more nuanced than that.

Most will take this tenement to mean that the outcome of an investment can’t be predicted by past performance. That limited interpretation would be incorrect.

Rather, what is meant is that price behaves in a way, which it has done so in the past. It goes up, down and sideways. We will not stop seeing prices go up, vice versa we will never stop seeing them fall or plummet.

We have also seen time and time again that there are price behaviours that repeat themselves that can often precede a type of price move.

You don’t need to be an expert at technical analysis to have seen this. I am sure that if you have looked at enough charts you will know for example, that a price which has been steadily going up has often done so for a while, and vice versa.

2. There are 3 types of trend

Prices go up, down and sideways which is simple enough to understand.

We also know that a price will pivot. That is, a change from going up to going down, and vice versa.

Therefore, we need to define when a price indeed is going up and Dow theory does that.

Definition of an uptrend and downtrend

Basically a trend is going up when there are a series of higher highs. And vice versa, price is going down when there are a series of lower lows.

A key thing to understand here is the trend doesn’t change until this sequence is broken.

Patterns

The other part of Dow Theory was the identification of patterns as possible means for helping to foresee price moves. It is important to note that we are not trying to predict future behaviour, what we are trying to do is determine LIKELY (but not guaranteed) behaviour IF the price acts in a certain way.

For example, if the price is going sideways, should the price move significantly in one direction it will likely continue to do so.

These patterns happen time and time again (reference to point 1 of History repeating itself.) In the example above the price had been falling, but it has stopped as we can see with the consolidation range which has formed (blue lines). The idea is the direction of the price move out of that channel is where price is likely to continue next.

In the example of this image it has broken up, but it could just as easily have broken down, meaning price was likely to keep falling.

The topic of patterns is extensive with multitudes to cover. For now it's suffice to know that a break of a pattern is an indicator that price is likely to continue to move in that direction.

Source: Reddit post 18/10/20

Support and resistance levels

If you have been able to read these graphs, you will also notice something peculiar , the price keeps bouncing off the blue lines.

That is because the pivot points are often viewed as support and resistance levels which can be levels of significance. Refer to the image below,

The 1st blue line is known as resistance because the price tried to break above but failed two times (noted by the two red circles) before it eventually went up.

The 2nd Blue line is known as support because the price fell to that level but didn’t keep falling (as denoted by the three red circles)

The idea here is that when price breaks resistance and/or support something happens.

This brings to an end our explanation of a key tenement of my strategy moving forward. When you read my commentary on Momentum Monday’s, I will be making more reference to these ideas and where appropriate expand on them.

My second indicator - Average True Range

Average True Range is a volatility measure that was originally developed by J. Welles Wilder in his 1978 book New Concepts In Technical Trading Systems. The indicator does not provide an indication of price trend, rather it simply the degree of price volatility.

The fact the indicator does not provide an indication or price trend, simply the degree of price volatility, means it can't be used in isolation.

And has been adapted as an overlay that investors can put onto a chart as you can with Stockopedia. There is a great explanation of it on the Stockopedia help file articles. Please read it here.

I find ATR trailing stop a very visual expression that I need to be on alert when price crosses above/below the ATR. One difference though that I apply from regular convention is I use a multiple of 2.5x times volatility, rather than 3x times.

This is because unlike many, I do not use the ATR as a sole entry/exit signal. I feel it is prone to whipsawing (which is a trader's nightmare).

Rather I prefer to use it as a means to show me the price action is currently on the winning (the the chart above) or the losing side. And I also use it to indicate to me that sentiment in the price may be changing.

To determine the exact point I will be in (or out) is more a combination of money management and Dow Theory looking for points of significance. I will discuss money management concepts next week.

But I have three rules for using the ATR trailing stop.

1. Don’t buy a stock if its price is below the ATR
2. If the price of a stock I hold is above the ATR, I keep doing so with little stress.
3. If the price of a stock I hold falls below the ATR then I look to set my stop loss level.

Buying close to support

I like to buy when the price retraces back to the ATR.

Why buy if the price is pulling back?

Because I won't have to wait long to know if I'm wrong.

If price keeps falling and breaks below the ATR then I can set my stop as I know volatility is working against me on the pullback.

For example: If I buy a stock which has boomed above the ATR so that there is a 20% difference between the price and ATR. Using my strategy I would have to wait until it pulled back all that way before then setting a stop loss. That could be 10% further down from that, and to me that is too much risk

General Indicators (not part of my trading plan - but I use them in my consideration)

Moving averages

I like to add a 50 day / 200 day EMA (exponential moving average onto the chart) Why? Because it helps me see the longer term trend. For an explanation on moving average please read more here.

When looking at daily charts to time your entry and exit it's good to see some perspective. Averages over longer time frames do this.

If I see the 50 day ahead (or above) the 200 day EMA then I know that over the past 2 or so months the price is doing better than what it has over the past 10 months.

Authors note: whether you choose 50/200, 20/60 or 60/260 days or some other combination is your decision based on your preference. I am not suggesting this as a sole trade indicator. As long as it gives sufficient perspective as to how the price has done in the past and provides context to current moves, that is great.

Moving averages can also be useful If I am feeling particularly nervous about the market at any stage. I may decide that I will only enter a position if it is trading above the 200 day moving average and remove any stock trading below it.

On Balance Volume (OBV)

Understanding volume is a key area of development for me that I am keen to keep exploring.

For the moment, I do not incorporate a volume element into my trading plan. I am starting to use OBV as another general measure to support my decision making, but am still studying the indicator to determine whether it can fulfil the role.

Most simply, OBV is a cumulative indicator that adds volume on up days and subtracts volume on down days.

So in orderly markets, normally one would see OBV rise on up days, and fall on down days.

What I look for, particularly in stocks I am holding, is when there is a divergence. In particular when a stock is going up, but the OBV is heading down. This may indicate there is little support of the recent run and therefore there is a risk that the price can come back.

For the moment, what I do is lift my stop loss to accommodate.

Moving Average Convergence Divergence (MACD) and Relative Strength Index (RSI)

I use MACD and RSI when looking at weekly charts of the market to gain perspective on the current trend of the broader indices.

For explanations please read:

MACD please read here

RSI please read here

Conclusion

So this basically summarises my approach

• Understand the broader market to appreciate how aggressive I can be.
• Then look for stocks going up and avoid those going down. I do this by looking for stocks creating new higher highs, are above their ATR, and hopefully trading above their moving averages with volume support.

These will be the concepts I will talk to in the Momentum Monday contributions.

Of course, all of what I have written above is dependent on the market operating in an orderly manner.

But we know stocks can be prone to surprises eg profit downgrades/upgrades, takeovers and/or geopolitical events. It is important to appreciate that many of these events are not predictable, but we know they will happen.

So next week in the final edition of this three-part instalment, I will discuss money management and of course how Stockopedia keeps me sane, sound and disciplined (and as those who know me most intimately will tell you, these traits do not come naturally to me.)

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