The High Risk High Gain Strat­egy

Momem­tum stocks are the ones that are cur­rently in favour by in­vestors. Karan Bho­jwani and Nikita Singh ex­plain how one can iden­tify mo­men­tum stocks even as DSIJ team iden­ti­fies top mo­men­tum stocks to in­vest in at this junc­ture.

Dalal Street Investment Journal - - CONTENTS -

Mihir Das is a 36-year-old mar­ket­ing pro­fes­sional from Mumbai. Af­ter hav­ing worked for over 10 years in the mar­ket­ing do­main, he had in­vested a de­cent cor­pus of his sav­ings in fixed de­posits (FDS) of his bank. Now his FDS were about to ma­ture and at ma­tu­rity he was go­ing to get a de­cent lump sum amount. He wished to in­vest the amount in the stock mar­ket. How­ever, he faced a ma­jor chal­lenge when look­ing for a stock to buy as there are more than 2,000 stocks listed on the In­dian stock ex­changes. Even when an in­vestor/trader fo­cuses on a small uni­verse of stocks, such as the 500 in All Or­di­nar­ies, there is still a larger ar­ray of choices than most in­vestors can deal with and this is an is­sue not quite re­stricted only to Mihir Das, but many other in­vestors/traders face sim­i­lar dilemma when they think about in­vest­ing or trad­ing. There are a large num­ber of trains at the plat­form to reach the des­ti­na­tion, yet which is the cor­rect one to board is the big ques­tion mark!

Given the large num­ber of al­ter­na­tives, it is not sur­pris­ing that in­vestors tend to con­cen­trate on stocks that are ev­ery now and then fea­tured on tele­vi­sion or in the fi­nan­cial press. As most peo­ple do not have an ob­jec­tive process for choos­ing stocks, more of­ten than not, they pur­chase stocks go­ing by the news sto­ries and other ran­dom rec­om­men­da­tions and en­dorse­ments by friends, rel­a­tives and col­leagues. How­ever, fol­low­ing these ran­dom rec­om­men­da­tions and en­dorse­ments usu­ally re­sult in ero­sion of your wealth. If you want to be suc­cess­ful in the stock mar­ket, you need to se­lect stocks us­ing an in­vest­ing style. This is a distinc­tive way of pick­ing stocks that gives you ob­jec­tive rules for se­lect­ing which stocks to buy and which ones to sell.

Hav­ing an in­vest­ing style will make you a bet­ter in­vestor than hav­ing no style at all. This is be­cause of the fact that styles are log­i­cal and with tens of thou­sands of in­vestors fol­low­ing their own styles, their con­certed ac­tions do cause stocks to climb up and down. If you do not fol­low any style, your odds for suc­cess will be thin.

All the great in­vestors have an in­vest­ing style. The se­cret to fruit­ful in­vest­ing is fig­ur­ing out and adopt­ing a strat­egy which suits your style and in re­turn make money, and us­ing it over and over again. Ob­vi­ously, your style may evolve over time and as con­di­tions change. All things con­sid­ered, you should never pick stocks ran­domly or based on im­pulse.

FOL­LOW­ING ARE SOME OF THE BEST/WIDELY USED IN­VEST­ING STYLES:

1. Value

2. Growth

3. Div­i­dend Yield

4. Mo­men­tum

1. Value In­vest­ing: Value in­vest­ing is an ortho­dox in­vest­ing style. This in­volves re­search­ing com­pa­nies and find­ing those with strong fun­da­men­tals that mar­ket par­tic­i­pants have not yet no­ticed or ap­pre­ci­ated. Value in­vestors look for cheaply val­ued stocks and buy them at de­pressed prices. The idea is to in­vest in stocks that of­fer great value and, as a re­sult, there is less chance of you los­ing money. In sim­ple terms, value in­vestors are bar­gain hunters who are will­ing to play for the long haul, more like a test match cricket!

2. Growth In­vest­ing: As de­fined by Wikipedia, growth in­vest­ing is a style of in­vest­ment strat­egy fo­cused on cap­i­tal ap­pre­ci­a­tion. Those who fol­low this style, known as growth in­vestors, in­vest in com­pa­nies that ex­hibit signs of aboveav­er­age growth, even if the share price ap­pears ex­pen­sive in terms of var­i­ous sta­tis­ti­cal met­rics such as price-toearn­ings ra­tio or price-to-book ra­tio.

3. Div­i­dend: Div­i­dend in­vest­ing aims to pick com­pa­nies that pro­vide a steady stream of in­come in the form of div­i­dend. In­vestors fol­low­ing div­i­dend style in­vest­ing buy stocks for in­come rather than for share price ap­pre­ci­a­tion. The key fac­tor to con­sider is the div­i­dend yield, which is the div­i­dend per share di­vided by the share price. These in­vestors usu­ally buy large, well-known com­pa­nies be­cause they tend to have track record of sta­ble and re­li­able earn­ings. This is es­sen­tial given that in­come in­vestors may rely on the div­i­dends paid out of com­pany’s earn­ings.

4. Mo­men­tum: Con­trary to con­ven­tional wis­dom of buy­ing low and sell­ing high, mo­men­tum in­vest­ing is a strat­egy which in­volves buy­ing stocks that have gone up over the pe­riod of last few trad­ing ses­sions, weeks or months, with an in­ten­tion to sell it at an even higher price and mak­ing a quick buck. Mo­men­tum in­vestors are look­ing for quick re­turns. They want to in­vest in stocks with the most rapid share price gains. The idea is that a ris­ing share price will con­tinue ris­ing – in other words that win­ners will keep on win­ning. In sim­ple terms, mo­men­tum in­vest­ing is like a T20 match.

Best traders and in­vestors con­cen­trate on one of the above cat­e­gories for in­vest­ment or trad­ing pur­pose. War­ren Buf­fett, for in­stance, ar­guably the great­est in­vestor of all time, is a ‘value in­vestor’. On the other hand, Martin Zweig and Louis Navel­lier are two ex­am­ples of suc­cess­ful fund man­agers who con­cen­trate prin­ci­pally on strong growth stocks. In­vestors who pur­sue

‘mo­men­tum stocks’ in­clude Richard

Driehaus, the found­ing fa­ther of mo­men­tum in­vest­ing, and the le­gend Jesse Liver­more.

As we have seen when it comes to in­vest­ment, there are dozens-if not hun­dreds-of in­vest­ment styles. But in this cover story, we are go­ing to talk about one of the most ex­cit­ing in­vest­ing strate­gies: ‘Mo­men­tum In­vest­ing’.

WHAT IS MO­MEN­TUM IN­VEST­ING?

In a nut­shell, mo­men­tum in­vest­ing is based on the be­lief that stocks which have per­formed bet­ter rel­a­tive to its peers will on av­er­age con­tinue to out­per­form and stocks that have un­der­per­formed rel­a­tively will tend to con­tinue to un­der­per­form. There is a fa­mous quote by Wil­liam J. O’neil: “What seems too high and risky to the ma­jor­ity gen­er­ally goes higher, and what seems low and cheap gen­er­ally goes lower.” Mo­men­tum in­vestors are not afraid of jump­ing onto the band­wagon and in­vest in the most pop­u­lar stocks of that time. When the re­alty stocks prices were reach­ing new highs in mid-2000s, ir­re­spec­tive of the amount of debt on the books or de­spite any strong fun­da­men­tals of these com­pa­nies, the stocks con­tin­ued to surge higher. Fol­low­ing the rule of mo­men­tum in­vest­ing, mo­men­tum in­vestors fol­low a trend. They be­lieve what’s mov­ing higher is likely to move higher and they bought re­alty stocks. But by the end of 2007 and the be­gin­ning of 2008, the mo­men­tum of these re­alty stocks was seen to be pe­ter­ing away and prices be­gan to change di­rec­tion, mo­men­tum in­vestors took the cue and sold the shares. In this case, there were two types of mo­men­tum in­vestors, one who had a proper en­try and exit plan, and the sec­ond who got stuck right at the top and kept on hold­ing to the stocks in hope that the stock price would bounce back to the cost price. That, of course, did not hap­pen and some stock prices even crashed from three dig­its to sin­gle digit. Hence, mo­men­tum in­vest­ing is a skil­ful strat­egy that in­volves tim­ing the en­try and exit and mon­i­tor­ing the po­si­tion on a reg­u­lar ba­sis.

IDEN­TI­FY­ING MO­MEN­TUM STOCKS

There are a num­ber of method­olo­gies avail­able in which an in­vestor can mea­sure mo­men­tum. Some in­vestors use a com­bi­na­tion of sta­tis­ti­cal and tech­ni­cal analysis to iden­tify en­try and exit points and find out which stocks cur­rently of­fer the best op­por­tu­nity for rapid ap­pre­ci­a­tion. Be­low are some of the method­olo­gies to iden­tify mo­men­tum stocks.

Rel­a­tive Strength:

Quite of­ten we see there are a few stocks which are in the spot­light and have a ten­dency to out­per­form when there is some trend move­ment in the stock mar­ket, while the ma­jor­ity falls be­hind or keeps trad­ing in­side the range. How­ever, look­ing at the out­per­for­mance of the stock, we tend to draw the con­clu­sion that this is an ex­pen­sive stock as it has had a mad run-up, only to find later that it has con­tin­ued to move higher. Now the big ques­tion that arises is: how to iden­tify such stocks? There is the con­cept of ‘Rel­a­tive Strength’ that comes into play when the de­ci­sion re­gard­ing the se­lec­tion of stock or sec­tor has to be done. Rel­a­tive strength is a mea­sure of share price mo­men­tum. It is used to iden­tify stocks that have done well in the past, on the as­sump­tion they will con­tinue to do well in the fu­ture. Stocks with high rel­a­tive strength will be ris­ing faster than the mar­ket and other stocks.

Higher Trad­ing Vol­ume:

One of the widely used strate­gies in mo­men­tum in­vest­ing is fol­low­ing the vol­ume. Ever since trad­ing/in­vest­ing be­gan, in­vestors have used vol­ume to get a read on where the stocks are headed. The vol­ume rep­re­sents the num­ber of shares bought and sold on any given day. Un­der­stand­ing vol­ume can pro­vide in­sight into stock’s be­hav­iour to help you de­ter­mine its over­all strength or weak­ness. In mo­men­tum in­vest­ing, trader/in­vestor fo­cuses on stocks that are mov­ing sig­nif­i­cantly in one di­rec­tion on high vol­umes. In gen­eral, a price change on rel­a­tively low vol­ume for a par­tic­u­lar stock sug­gests an aber­ra­tion or ma­nip­u­la­tion, whereas a price change on high vol­umes is con­sid­ered a gen­uine move. This is be­cause a high vol­ume gives an in­di­ca­tion that smart money is ac­tively par­tic­i­pat­ing in the move. The ba­sic the­ory is that if price and vol­ume are mov­ing in the same di­rec­tion, the trend of the stock price will con­tinue.

Stan­dard De­vi­a­tion:

Stan­dard de­vi­a­tion is de­fined by Investopedia as a mea­sure of the dis­per­sion of a set of data from its mean. The more the data is spread apart, the higher the de­vi­a­tion. In sim­ple term, stan­dard de­vi­a­tion is a mea­sure to know how much an in­vest­ment de­vi­ates from its av­er­age. For ex­am­ple, if ₹50 is the stan­dard de­vi­a­tion for a stock whose av­er­age price is ₹400 and if the stock is cur­rently trad­ing at ₹550, this tells mo­men­tum in­vestor two im­por­tant things. One, the stock is very vo­latile and two, it has a lot of pos­i­tive mo­men­tum since it is cur­rently trad­ing three stan­dard de­vi­a­tions above its av­er­age.

Mov­ing Av­er­ages:

Mov­ing av­er­age is a sim­ple tech­ni­cal analysis tool which helps trader to spot the di­rec­tion. All mov­ing av­er­ages are called lag­ging in­di­ca­tors, which means the ac­tual trend changes be­fore the mov­ing av­er­ages gen­er­ate a sig­nal. Due to this lag, many of the traders ig­nore this sys­tem, but this does not make mov­ing av­er­ages to­tally un­pro­duc­tive. Mov­ing av­er­ages smoothen prices and pro­vide in­vestors/traders with a cleaner price plot, which makes it eas­ier to iden­tify the gen­eral trend. This strat­egy em­ploys two mov­ing av­er­ages to de­fine the trad­ing bias. The bias is bullish when the shorter mov­ing av­er­age moves above the longer mov­ing av­er­age and the bias is bear­ish when the shorter mov­ing av­er­age moves be­low the longer mov­ing av­er­age.

Rel­a­tive Strength In­dex (RSI):

De­vel­oped by J. Welles Wilder, the Rel­a­tive Strength In­dex (RSI) is a wellestab­lished mo­men­tum-based os­cil­la­tor which is used to mea­sure the speed (ve­loc­ity) as well as change (mag­ni­tude) of di­rec­tional price move­ments that give a clear mea­sure of the strength of a trend. In other words, the mo­men­tum mea­sures the speed and the mag­ni­tu­di­nal change in price move­ments. The RSI of a stock with a strong up­trend mo­men­tum or bull phase tends to re­main in the range of 40 to 90 with the 40-50 zones act­ing as a sup­port. Dur­ing a down­trend or bear mar­ket, the RSI tends to stay be­tween the range of 10 to 60, with the 50-60 zone act­ing as re­sis­tance points.

The Rate of Change (ROC):

The Rate of Change in­di­ca­tor (ROC) is of­ten re­ferred to as a purely mo­men­tum os­cil­la­tor. As the name sug­gests, ROC os­cil­la­tor mea­sures the rate of change in price, based on the look-back pe­riod. The ROC cal­cu­la­tion com­pares the cur­rent price with the price “n” pe­riod ago. The ROC in­di­ca­tor mea­sures the cur­rent price with the price for the de­fined pe­riod. The ROC os­cil­la­tor moves around the 0-line from pos­i­tive to neg­a­tive or from neg­a­tive to pos­i­tive, de­pend­ing on the mo­men­tum. When the mo­men­tum in­creases, the ROC os­cil­la­tor moves from the neg­a­tive to pos­i­tive, that is, above the 0-line, and when mo­men­tum de­creases, the ROC os­cil­la­tor moves from pos­i­tive to neg­a­tive, that is be­low the 0-line. Apart from the above men­tioned meth­ods, there are a wide-col­lec­tion of tech­ni­cal tools used to as­sist the mo­men­tum-based ap­proach, in­clud­ing chart read­ing, sup­port and re­sis­tance lev­els, os­cil­la­tors, and so forth. In the mod­ern world where there are large num­ber of screen­ers, soft­wares and in­for­ma­tion is eas­ily ac­ces­si­ble, the task for trader is to se­lect the best tool or a com­bi­na­tion of tools that com­ple­ment one an­other and pro­vide a means to study the mar­ket in a re­li­able man­ner and of­fer well-de­fined en­try and exit points. For a ma­jor­ity of in­vestors fol­low­ing mo­men­tum in­vest­ing, the pri­mary analysis starts with defin­ing the con­di­tion of the trend in the price. By and large, mo­men­tum is ro­bust at the ini­tial phase of a trend and frag­ile at the con­clud­ing phase just pre­ced­ing a trend re­ver­sal. To draw an anal­ogy, this is sim­i­lar to the way a ball trav­els faster when leav­ing your hand and pro­gres­sively re­duces its ve­loc­ity of as­cent be­fore it reaches its pin­na­cle, from where it re­verses its di­rec­tion and falls back to earth.

MO­MEN­TUM IN­VEST­ING MAY BE IDEAL FOR YOU IF:

1. You are an ag­gres­sive in­vestor with a high tol­er­ance of risk. In straight­for­ward terms, it im­plies you are an ex­pe­ri­enced in­vestor or a young in­vestor hav­ing ad­e­quate time to re­coup any mis­for­tune.

2. You are dis­ci­plined and can ad­here to your strat­egy de­spite volatil­ity in few stocks.

3. You fol­low a proper ‘stop-loss’ strat­egy be­cause the hottest stocks tend to fall much faster than the mar­ket when con­di­tions turn the other way around.

4. You should not be emo­tion­ally at­tached to any stock and you have to be good at get­ting out of bad in­vest­ment quickly.

5. Since mo­men­tum in­vestors fo­cus on the fastest grow­ing stocks in the strong­est sec­tors of the mar­ket, when the stock or sec­tor loses mo­men­tum, they move on to the next big thing to avoid be­ing caught in a sharp cor­rec­tion. Hence, a mo­men­tum

port­fo­lio re­quires con­stant at­ten­tion as you may want to make changes to your port­fo­lio more of­ten than a value, in­come or low beta in­vestor.

BEST TIME FOR MO­MEN­TUM IN­VEST­ING:

There are a num­ber of in­vest­ment strate­gies fol­lowed by in­vestors across the globe and it is a proven fact that dif­fer­ent styles of in­vest­ing work in dif­fer­ent mar­ket phases or cy­cles. It is crit­i­cal to un­der­stand that mo­men­tum in­vest­ing is no dif­fer­ent; the ef­fec­tive­ness of a mo­men­tum strat­egy de­pends on the phase in which the stock mar­ket cy­cle is.

His­tory sug­gests that the best time to use a mo­men­tum strat­egy is when stocks are mov­ing in an up­trend, which is gen­er­ally mid to late cy­cle in a bull mar­ket. Like­wise, the strat­egy could be repli­cated in a bear mar­ket if the down­trend in the stock mar­ket is pro­longed. Mo­men­tum tech­niques gen­er­ally wit­ness a draw­down or whip­saw near the mar­ket tops and bot­toms as there is gen­er­ally a move in the stocks that leads the mar­ket to these points in the cy­cle.

CON­CLU­SION:

Gen­er­ally speak­ing, the widely used phi­los­o­phy in the stock mar­ket is to ‘buy low and sell high’ and eq­uity in­vestors are ad­vised to stay in­vested for a good enough time to en­sure that they get good re­turns. This is be­cause the risk in­her­ent in eq­ui­ties is re­duced over time and the pos­si­bil­ity of earning higher re­turns in­creases. How­ever, from the way the stock mar­ket has been mov­ing up with gusto, it seems that some of the in­vestors are im­pa­tient and are look­ing to make quick bucks by adopt­ing mo­men­tum in­vest­ing style. Though this strat­egy may be prof­itable at times, it can also pro­vide a roller­coaster ride. How­ever, to be able to make money con­sis­tently through this style of in­vest­ing, one needs to have a dis­ci­plined ap­proach be­cause mo­men­tum in­vestor will have to make fast risk man­age­ment de­ci­sions based on limited in­for­ma­tion when the mo­men­tum changes or the mar­ket turns its course. The mo­men­tum in­vestor surely needs a lot of self-be­lief.

It is seen that mo­men­tum in­vest­ing is in spot­light dur­ing the bull mar­ket phase be­cause the prof­its can be in­cred­i­ble. How­ever, once the bull phase peters away and the stock mar­ket cy­cle moves to the con­sol­i­da­tion or cor­rec­tive phase, the vast ma­jor­ity of mo­men­tum chasers go back to their old strat­egy. Hence, it is im­por­tant to un­der­stand your risk pro­file and fol­low an in­vest­ing style that suits you the best.

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