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HomeTradingA Step-by-Step Guide to Building a Momentum Trading Portfolio

A Step-by-Step Guide to Building a Momentum Trading Portfolio

Introduction  

In the realm of trading and investing, impulsive decision-making can be likened to an untimely acne breakout on prom night—it can undermine your overall success. To steer clear of these pitfalls and make informed choices, consider adopting the momentum strategy detailed in Andreas Clenow’s book, “Stocks on the Move.” Below, we provide a detailed, step-by-step roadmap to constructing and executing this systematic approach. 

Step 1: Choose your trading day 

Rule: Establish a Fixed Trading Day, e.g., Mondays 

Simplicity and cost-efficiency are paramount in systematic trading. Allocate one specific day each week for your trades, such as Wednesdays. This practice eliminates the need for constant monitoring and minimizes trading fees. 

Step 2: Rank your stocks 

Rule: Prioritize Stocks with Consistent Momentum 

To maximize returns, it’s crucial to identify stocks that exhibit steady upward momentum. Develop a ranking system based on the following parameters: 

Criteria for stock selection: 

  • Universe: Start with the Nifty 500
  • Check whether the index (Nifty 500) is trading above its 200-day moving average (DMA) as a signal to begin investing. 
  • Utilise exponential regression to measure momentum. 
  • Exclude stocks with significant price swings exceeding 15% in the past 90 days. 
  • Determine position sizes to achieve risk parity using the Average True Range (ATR) and a predefined risk factor. 

We use Exponential Regression to rank stocks based on momentum. This involves fitting a line to a stock’s price data. Linear regression helps find the best-fitting line by determining the starting point (intercept) and how much the line should move up or down for each data point (slope). 

The slope is crucial because it reveals the direction of the stock price movement. However, linear regression expresses the slope in currency units, making it challenging to compare stocks of different prices. To address this, we use exponential regression, which expresses the slope in percentage terms. 

The exponential regression slope indicates the average daily percentage move of the stock. This number often has many decimal places, making it hard to interpret. To make it more understandable, we annualize it. For example, if the exponential slope is 0.0006 per day, it translates to an annual gain of about 16%. 

To rank stocks, we calculate the exponential regression slope for each stock, annualize the values, and sort them. This provides a ranking based on momentum. Additionally, we want stocks with smooth upward trends, not those with erratic price gaps, which is measured by the coefficient of determination (R2). 

R2 tells us how well the price data fits the regression line. A low R2 suggests poor alignment between the data points and the line, while a high R2 indicates a strong fit. 

To combine momentum and quality, we multiply the exponential regression slope by R2. This gives us a comprehensive ranking. 

We also adjust position sizes to distribute risk evenly among stocks since each stock has different volatility. Two more filters are applied: stocks must trade above their 100-day moving average (DMA) to be considered a buy candidate, and they are disqualified if there has been a price move larger than 15% in the past 90 days. These filters help ensure that selected stocks truly exhibit momentum. 

Key concepts: 

  • Exponential regression provides a momentum measurement expressed in percentage terms. 
  • Linear regression is employed to calculate the slope of a stock’s price movement. 
  • The coefficient of determination (R2) assesses how well price data fits the regression line. 
  • Combining the exponential regression slope and R2 yields a robust ranking methodology. 
  • Position sizing aims to distribute risk uniformly across different stocks. 

Step 3: Remove underperforming stocks 

Rule: Sell Stocks Falling Below the Top 20% Ranking or Trading Below Their 100-day Moving Average (DMA). 

Pruning underperforming stocks from your portfolio is essential. This practice prevents lacklustre assets from dragging down your overall returns. However, it’s crucial to strike a balance between selling and incurring unnecessary transaction costs. 

Conclusion  

By implementing a systematic momentum investing strategy, you streamline your decision-making process, enhance efficiency, and zero in on consistently profitable stocks. By adhering to a set of clear and well-defined rules, you’ll be better equipped to achieve your overarching goal of generating profits in the dynamic world of trading and investing. This approach offers a structured, data-driven, and calculated path to success in the financial markets.

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