The Building Blocks of Momentum Trading

When I was in kindergarten, I loved to pile blocks as high as I could and then tip them over. Little did I know, I was preparing for my career in the stock market and learning how to play momentum. Such block-building is similar to building expectations for a trade.

First, I assess the momentum affecting the trade and the potential of the trade given current circumstances. Various forces impact a stock: news, the stock's individual pattern, and market and sector momentum. To organize and combine these different forces, I think of them as positive and negative building blocks, piled together to create the relative strength or weakness of a stock and the potential of a trade.

I like to start by considering the market pattern blocks. I assess the potential of the market by tracking the most recent average action. Generally, I play stocks with high average daily volume that participate closely with the market. Then I track the average moves of sector leaders and high-volume participators that aren't being affected by news momentum.

I determine their average drop from the open and their average first climb. I also consider the time frame of the moves. Obviously, some will move more, and some less. But if you track similar price ranges, you will see a lot of similarities in the average moves and can gain a feel for potential.

Next, I consider the recent average potential within the sectors. Because sectors will move in cycles, strength and weakness, I also need to weigh that momentum into the assessment.

Then I consider the patterns in market reactions to stocks impacted by news. Has good news been rewarded? If so, by what average amount? Or have profit-takers been taking profits off the table? What have been the average reactions and the timeframe of those reactions?

I next consider premarket gaps. The average gaps in the market, and the action within those gaps, will give me an overview of the mood going into the open. Futures also will give a glimpse. That mood will add either upward or downward momentum to my play, which is affected by that overall market mood.

After that I consider the gap of my candidate in relation to that average. Is my stock's gap greater or weaker than the average market gap? Greater or weaker than the average sector gap? Does my stock have news that is creating that gap? Fresh news momentum will add either positive or negative momentum.

I also track excessive gaps. For instance, a mildly positive gap is a sign of positive momentum, and usually will be met with a certain amount of early buying. An excessively positive gap, however, creates profit-taking incentive that is initially harder to resist, and so often will be met with a stronger counter-reaction. So we want to consider the reason it is gapping and how the market has been treating those types of trades. Excessive gaps will be more reliant on patterns.

To illustrate how I combine these building blocks, let's take a look at WebEx Communications (WEBX Quote) on Oct. 22.

WebEx Building Blocks WebEx felt the market's Oct. 19 momentum fading early on Oct. 22

First, I look at the recent pattern in the market. Although Friday, Oct. 19 ended strongly, the early action was a bit narrow. At the market open on Oct. 19, we had selling until value targets were reached, and then it slowed. The day ended with a climb that could be a sign of a market change, but the lack of follow-through on the morning of Oct. 22 made me leery of adding many positive blocks based on the market momentum. The premarket mood Monday appeared neutral to weak, and volume was low. So we really had no indication, up or down. In general, Mondays tend to be slow, and a time when traders are more apt to hold back and wait for direction.

Next, I consider the gap. WebEx that day had news of a deal with France Telecom (FTE Quote), and with BEA Systems (BEAS Quote) for multimedia conferencing services integration. When considering how many positive blocks to add on a news story, one must look at a chart for a broader perspective.

Participating in the Market Like many stocks, WebEx is recovering from September doldrums

WebExX was climbing off September lows of about $16 and participating in the market recovery, moving up near $30 on Friday, to end at the top of the day's trading range. That shows market participation. So if the market started to buy, it would be a likely candidate to participate.

Was the gap extreme? Not really: It only gapped about a buck. Had WEBX been up Friday from $26 to end at $36, and then gapped up to $37, I would say a counter-reaction would be more likely. But the WEBX gap was not excessive, so only positive blocks could be added there. So considering the average patterns, the neutral market and the positive news momentum, we expected a shallow pullback from the open, and the $30 barrier near Friday's closing price to hold. If the market and the stock were to see any buying, the stock would climb close to that barrier. The plan followed through, and we were rewarded.

It takes some time and energy to track these average moves and weigh all of these variables to assess the potential of your play. But the building blocks pay off.