In the last article, I described what momentum investing is, and how it can be broadly applied to a personal investment portfolio. By acting as an indicator of when to buy into an opportunity that has already been established as having a strong value proposition, a momentum indicator can add incremental returns to an investment, without greatly increasing the risks of the investment itself.
Today, I’m going to go into detail about two kinds of momentum metrics that can be used to evaluate purchasing and selling opportunities, as they would impact a personal portfolio.
The first metric that I use to examine the timing of a value opportunity is called the Fast Stochastic Oscillator(FSTO). The FSTO is designed to follow momentum trends, as opposed to prices or volumes, and therefore provides an indication of whether or not a position is setting up for a directional reversal, or maybe a trend consolidation. Essentially, it identifies opportunities as being statistically within the norm of trading.
The results are then illustrated between a range of 1-100. A lower score indicates that a position is showing downward momentum, while a higher score indicates the opposite. If the FSTO score remains at an even 50, it suggests that the position is trading at an even rate, and with very little change in momentum.
The second metric I use to evaluate market timing is called the Slow Stochastic Oscillator (SSTO). The SSTO is a smoothed out moving average of the FSTO, and it acts to serve as my voice of reason when examining momentum. While the FSTO is a very dynamic metric that can sometimes be hard to understand, the SSTO moves much more slowly, and therefore better illustrates trends in the momentum of a position. I find this metrics serves as a much better illustrator of underlying opportunities.
The trick to using these two metrics is to combine them into a single model that searches for divergence. What we want to find here is changes that represent fundamental opportunities, not quick arbitrage jumps. The way we do this is by searching for overlaps. Specifically, this is done by layering the two metrics over top of each other. When the FSTO crosses the SSTO from below, and the SSTO is already moving in an upward direction, we can take it as an indication that the momentum of the security is increasing towards the positive side.
This suggests that we are entering a buying opportunity. Ideally, this would be happening at the bottom of the Oscillator’s spectrum (ie. below a value of 20), indicating that the position’s momentum is either returning to is equilibrium position, or is bouncing back from a short-term decrease. Regardless, it presents a strong argument for timing the purchase in the short term. The opposite is then true for when the FSTO crosses the SSTO from above.
With these metrics in our repertoire, we gain the ability to understand how it is that short-medium term swings in prices will impact our portfolio, and we gain a slight edge in mitigating the risks associated with momentum related volatility.
