Trading Rule – “Always stay on the right side of market momentum”

WHAT DO WE UNDERSTAND BY MOMENTUM? IT IS HARD TO DESCRIBE IN WORDS BUT IF YOU ARE IN THE MARKET YOU UNDERSTAND WHAT MOMENTUM IS ALL ABOUT. IT IS THE UNDERLYING TREND IN THE MARKET WHICH CAN EITHER BE AN UPTREND OR A DOWNTREND. IT CAN BE A SELL-ON-RISES MARKET OR IT CAN BE A BUY-ON-DIPS MARKET. THIS RULE IS CRITICAL BECAUSE IT GUIDES YOU ON HOW YOU MUST TREAT YOUR POSITIONS AND HOW YOU MUST KEEP STOP LOSSES FOR DIFFERENT TYPES OF POSITIONS. THE MORAL OF THE STORY IS TO ALWAYS BE ON THE RIGHT SIDE OF MOMENTUM

LEARNING THE LESSONS FROM JESSE LIVERMORE

One of the greatest stock traders in history, Jesse Livermore, famously said that, “There is no bull side and no bear side. There is only the right side”. What Livermore meant was that the key to trading is to stay on the right side of market momentum. When the undertone is weak, smart traders use every rise to sell in the market. Similarly, when the undertone of the market is strong then savvy traders will use every dip to buy into stocks. Again, there is a corollary to this point. You must not only focus on market momentum but also on stock momentum. Let us understand this more clearly. The Nifty was up by 25% each year in the last 2 years but during this period pharma was a gross underperformer. It is not just enough to identify the market momentum correctly but it is also important to trade in stocks which have momentum in their favour. Even in a fantastic bull market as we saw in the last two years, you would not have made any money buying into pharma stocks.

GOING AGAINST THE TIDE ONLY WORKS IN THE VERY LONG TERM

The legendary economist John Maynard Keynes once said that “Markets can be irrational much longer than most of us can be solvent”. That is the crux of trading in the markets. You may feel that pharma is a great contrarian bet but there is a limit to how much you can wait. For example, if you had bought Lupin or Sun Pharma 3 years back, you would still be out of money. Of course, you may eventually be right but as a trader you do not have the luxury to wait forever. Considering your time constraints, it becomes more important to stay on the right side of momentum. Remember, momentum is what gives you positive results in the short term. Searching for deep value may give you results in the long term but you are not sure how long that will be. When you are trading on the same side of momentum, you are able to churn your money faster and therefore your ROI is much higher. Your stop losses are still going to hit occasionally but if you are on the right side of momentum then you are likely to be right more often than wrong.

Remember a basic rule – Trading equities or any asset is not simple enough to be boiled down to a simple quote” – Andreas Clenow
6 WAYS TO STAY ON THE RIGHT SIDE OF MOMENTUM

  1. There is a long term trend and there is short term momentum. Don’t confuse these two things. For example, a bull market in equities may last for a period of 3-4 years. But within this broad trend there will be a plethora of sub-trends that could be either in the same direction of momentum or on the opposite side. The idea of trading is to ensure that you are able to read these sub-trends and trade accordingly.
  2. While the short term trend creates the momentum and helps you to trade, it is the longer term trend that will be your guide. For example, if we are in the midst of a long-term secular bull market then buying on dips makes a lot more sense. Similarly, if you are in a long term bear market then selling on every bounce makes a lot more sense. Your momentum trade are ultimately driven by the larger trend.
  3. Remember, the stock market is the king and you as a trader are a student of the market. Don’t try to outguess or outsmart the market. The market, after all, represents the collective wisdom and follies of millions of investors. Good, bad or ugly; it represents the market reality and there is not running away from that. A good trader always reads momentum as a student of the market, rather than outguessing it.
  4. Learn to distinguish the trend from the noise. Noise can be extremely short term ranging up to 1-5 days. This noise is typically created by specific trades, news flows, block deals etc. Noise is not trend and you cannot really trade based on noise. That is because noise is just too random to be of any meaningful use and too unpredictable. The challenge is to remove the noise and delineate the trend to trade.
  5. It is very important to understand the triggers that create trend shifts. What shifts the trend from a negative trend to a positive trend? There could be a variety of triggers ranging from a reformist budget, positive news flows, high-level reforms announcements by the government, positive IIP and GDP data, low inflation etc. These triggers normally act as lead indicators for trend shifts.
  6. Remember, momentum is a mix of direction and force. It is not just sufficient to understand the direction of momentum but also the force of momentum. Weak momentum lasts for shorter tenures while strong momentum lasts longer. You need to frame your trading strategy accordingly. Getting the combination right works better!

TRADING IS PREDOMINANTLY ABOUT MOMENTUM

Traders always need to stay on the right side of momentum. Focus on the direction and the strength of the momentum and also keep a tab on the triggers that can lead to shifts in momentum. That is the first lesson for any trader in the market!

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