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Momentum Trading

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PostPosted: Sat Apr 16, 2005 7:20 pm    Post subject: Momentum Trading Reply with quote

There are many traders who use only technical analysis and momentum to trade. However, I believe, that methodology doesn't work most of the time. Consequently, I use a value methodology, similar to Buffett and Soros, which does work most of the time (e.g. finding the highest return to risk ratio stock, at a point in time).

Nonetheless, sometimes, momentum trading works very well. Late last week, The Dow fell over 400 points in three days, and SPX fell below multi-year support at 1,160, closing at 1,142. When the steep sell-off was in progress, I suspected selling would accelerate from stop loss selling. So, I was cautious in my long positions and heavy in cash. However, I didn't take bold short positions. Consequently, over the three-day sell-off, I ended-up with net losses, although not large amounts, instead of making large gains.

Unfortunately, when selling accelerates, it's difficult to get into position to take advantage of further selling. When the Dow fell about 200 points Fri, that happened to be options expiration day, i.e. a few hours before Apr options expire. OEX options have huge leverage, just before they expire, because of low time value and high strike prices. SPX has higher strike prices. However, they don't trade the Fri before expiration. I believe, of all the stocks that have options, on day of expiration, OEX has the highest strike prices.

OEX traded in steps throughout that Fri, normally for one or two hours per step (although, the time intervals shortened as the day progressed). OEX first traded between roughly 553 and 556, then between 552 and 555, then 551 to 553, then about 550 to 552, and then broke down and fell sharply roughly 30 minutes before the close, closing at 547 1/2. The falling steps represented battles, for support (and resistance) levels, which are resolved one way or the other.

When the market opened low that Fri, I bought OEX Apr in-the-money calls, which moved roughly one-for-one with OEX. Also, I may add, SPX futures and OEX options lead OEX moves, and when the market opens very weak, there is dumping of next month calls. Moreover, in the chaos of a weak and volatile open, it's normally best to trade next month in-the-money options, because value can be easily and quickly estimated by using only intrinsic value.

The volatility indices rose sharply over the three-day sell-off. However, there wasn't enough volatility to get into position to buy puts. When the market fell (e.g. to the support battle areas), I bought calls, and when the market rose, I sold most of those calls (on small moves for big gains). If the market rose higher (e.g. another OEX one point rise), I would have bought puts, or sold the rest of my short-term calls, if I had them, because my heavy position in long-term calls would hedge the relatively light position in short-term puts, in case the market rose higher.

OEX fell from 566 1/2 to 547 1/2 over the Wed to Fri sell-off. So, there were excellent opportunities to make huge gains with Apr puts. However, on Fri afternoon, when the sell-off accelerated, almost all the short-term technical indicators were severely oversold, which made it difficult, for me, to buy puts. Nonetheless, huge gains could have been made using a momentum approach with Apr puts.
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