Beliefs and (Meta-)Principles in a Momentum Trading Strategy

Preliminary ideas and formulation of trading strategy

This post will serve to articulate and refine my beliefs and principles in momentum trading (buy strong performers high and sell higher), comparing and contrasting it with other types of trading strategy I’ve researched or tried out.

I’m writing this to help retain what I learned from my reading (and subsequent re-reading) of both books by Mark Minervini, who was featured in Jack Schwager’s Market Wizards:

  • Trade Like a Stock Market Wizard (published April 11, 2013)
  • Think and Trade Like a Champion (published January 1, 2017)

I’ve read many dozens of books on trading, and these were noticeably good, and Minervini’s style making a lot of intuitive sense to me. It comes directly from his hard-earned experiences and thinking as a successful trader who has made a fortune, audited and verified for Schwager’s books, and not from an “author.”

I don’t believe there’s any single best methodology for trading the markets, since each must be tailored to the personality, strengths/weaknesses, and preferences of the trader along with other contexts such as capital scales, market environment. But I believe this momentum trading is one promising component of my overall trading strategy, with the other involving options consisting of shorting options spreads roughly 80% of the time and going long options (spreads) the other 20% of the time. I have much written elsewhere on options, but they’re a perfect complement to momentum trading of equities.

I will try to distill these to beliefs and why I believe, as well as important principles, in roughly descending order of importance. In the future, I plan to dive into each of these sections in entire (series of) posts, so please consider this as preliminary and high-level introduction that’s helping me to articulate and refine my thinking.

1. Risk First Orientation and Profit/Loss Stability

Reduction of risk and wild swings in my Profit/Loss statement is the impetus for why I’d like to trade smaller positions on smaller timeframes, since I’ve been burnt holding larger positions for larger timeframes seeing huge gains turn into small gains or even losses.

I personally do not doubt one bit the power of value investing via long-term buy-and-hold based on financial analysis, and Warren Buffett is the prime example of its power. However, even with the big assumption that I personally have the skill to do the fundamental analysis for value investing, it may take years and massive P/L swings for me to get there.

Meanwhile in the short term, stock price movement is driven by supply and demand and general market conditions that can drive price so far from fundamental value that that fundamental value is effectively irrelevant.

My question is what would help to reduce the risk?

It starts with more/smaller positions at smaller time frames, with much smaller stop losses. The target is 4–8 positions at any one with stop losses roughly at 10%, which ranges from 1.25% for 8 positions and 2.50% for 4 positions. I don’t plan to take more positions than this since it’s practically much harder to keep tabs on more positions, marginal benefits of diversification rapidly goes down with additional positions.

2. Price and Volume as Reality, Technical Analysis Patterns as Derived

I’ve always been extremely skeptical of chart patterns in Technical Analysis since I believe they’re highly subjective and at best just backwards-looking and descriptive rather than forwards-looking and predictive. Most of TA is more akin to voodoo or astrology, especially using such ideas that sound scientific but are really pseudo-scientific such as Fibonacci Levels. And of course, the obvious question is that if these patterns did work, why aren’t more people using them rich, and wouldn’t hedge funds with brilliant people have captured these inefficiencies already?

However, if we consider what chart patterns are, they’re nothing more than price and volume, expressed in their derivative quantities such as moving averages, trend lines, oscillators, etc. That price and volume are indeed real phenomena in the markets, so the more closely we stick to price and volume, the more we stick to real phenomena.

What changed my mind about price and volume is a combination of my experience trading the markets as well as my studying of perhaps the greatest discretionary trader ever, George Soros, and his ideas about Reflexivity in the markets.

Fundamentals are obviously distinct from trading/risk management, but Soros believes fundamentals are NOT absolute nor objective, as assumed to be in traditional finance. In getting to these non-absolute and non-objective long-term fundamentals, there may so much sentiment, uncertainty, interpretation of financials, and even unknowable changes in law and regulation, that the assessment of some intrinsic “value” has as much error as in price and volume in TA. That error and uncertainty would cause such massive price swings that in theory have absolutely nothing to do with the company the stock represents, that that intrinsic value is effectively meaningless or non-existent.

So this is why I not only believe that price and volume matter, but they may matter more than any modeled assessment of fundamental value, and that’s why I’m interested in them. Like with anything, there’s also skill involved.

3. Compounding of Capital

One problem with even profitable long-term holds is that your capital may sit there idly while waiting for the upswing. This can work, but consider the following compounding.

  • Two 40% returns = 96% return
  • Four 20% returns = 107% return
  • Twelve 10% returns = 214% returns

It’s far easier to get those more frequent and smaller percent returns than one very large percent return. Furthermore, smaller percent wins can occur on much shorter timeframes so the compounding effect of more trades can occur on a smaller timeframe than one large trade.

Of course, it’s also possible to lose more frequently, and that’s where the next idea of quick stop losses are crucial.

Risk Management is Key

4. No Big Losses: Cut Losses Quickly and Let Your Winners Run

Minervini showed a simple but instructive example where if he simply capped his losses at 10%, his performance improved massively. The reason is because of the geometric nature of losses on consecutive tries.

For example, if we have 2 years of 50% gains followed by 1 year of a 50% loss, that only comes out to a 12.5% gain over three years, which is only about 4% per year. Clearly, protecting the downside may actually be more important than striving for return on the upside.

Not only is this good for less volatility in an overall portfolio’s equity curve, but it’s much better psychologically.

On the other hand, it’s important to allow winners to run, even if not the entire position since it’s still important to take some profits to reduce risk or ensure a win regardless of the future stock movement.

5. Reward to Risk of 3:1 (ideally) or 2:1 (at least)

Let’s simply look at trade setups agnostic of the context and expectation of win, with simple expectation equation:

Expectation = Probability(Win) * Win - Probability(Loss) * Loss

Note that you can get positive expectation with any probability, whether low probability and high amount won or high probability with small amount won.

There are plenty of setups in the market such that you can win only 50% of the time and still be profitable. You can even be correct less than that if you get a larger win.

Using simple support and resistance and movement weighted by volume, it’s definitely possible to get into contexts where you get 3:1 reward to ratio. This is your edge. You don’t need to call it correctly, but just be able to find these setups, and repeat.

As for scaling, it’s possible to scale in capital sizes or more positions, so long as you’re able to realize this reward to risk ratio, the issue then simply becomes taking as many shots as possible with a small edge. No need to bet all-in on any bet, or take huge P/L shots. You would be mathematically disfavored to take so many losses on 3:1 or 2:1 shots that it becomes effectively impossible to lose so long as your sticking to the rules.

6. Meta Rules in Poker as an Analogy

Many successful traders believe that poker is the best training for trading the markets and I could not agree more wholeheartedly.

What’s interesting is that there are plenty of meta-rules of the game that have absolutely nothing to do with the card rankings, or variant of poker, or even poker-specific strategy and tactics that can be employed to give a winning edge “without even looking at the cards themselves.”

These may include:

  • Proper bet-sizing as risk management
    Can’t bet too big even with Aces since, for example, you are still only a 4:1 favorite against a lower pair so losing that one time can bankrupt you.
    - Trading: this may express itself as not betting too much of your equity in any specific trade even if you have a very clear advantage.
  • Table selection
    You don’t have to play every game and try to beat the best players, but be opportunistic and only pick the tables with the best conditions with the weakest players.
    - Trading: You can simply sit on cash until a very clear and favorable opportunity appears
  • Position to act
    Those who are last to act have the benefit of seeing how others act, which is effectively playing with higher quality cards.
    - Trading: Wait until you have clear setups where the odds are in your favor such as when a stock blasts off from it’s 52-week high on much greater than average volume

If we follow these “meta” rules, we don’t necessarily need a deep or perfect understanding of a company that’s required in value investing, we just have to adhere to universal “meta” rules to give us an edge. And that edge does not even have to be very large. So long it’s positive and repeatable, we can use it to form the basis of profitable trading. y

Conclusion

The actual implementation details of the principles above is obviously where the difficulty is, and that’s where experience and the hard work of researching and analyzing other trades comes in.

For example, we still need to screen for stock in a long-term upward trend displaying upward strength on high volume. And then we must execute via defined entries, holding periods, and exits, as well as initial stop losses on entry and managed stops as the trade matures. It’s probably equal parts art and science.

However, my view is that if we keep the big picture in mind such as risk management and position sizing, then we don’t need to be very precise with which stocks so long s their fundamentals are of some threshold quality and the stock is moving on high volume to latch onto the momentum strategy.

These thoughts are still a work in progress, but this post was very important for me to digest the ideas in Minervini’s books about momentum trading and highlight the clear rationales for a momentum based equity trading strategy of 4–8 equity positions at a time.

AI/full-stack software engineer | trader/investor/entrepreneur | physics phd