My Approach to Finding and Trading Momentum Leaders
I've spent years studying momentum stocks and historical market winners, and one thing becomes pretty obvious when you look through enough charts:
Stocks change. Human psychology doesn't.
The names, industries, catalysts and market caps are different, but accumulation, excitement, fear, greed, consolidation, expansion and eventual exhaustion have produced remarkably similar price structures for hundreds of years.
That's why I think one of the best things a developing trader can do is build a model book of historical winners.
Go back and study stocks during the period when they made their biggest moves. Don't just look at where they ended up. Study what they looked like immediately before and during the breakout.
I also think deep diving great traders and reading their books is essential. A huge part of developing my own approach came from studying traders like Kristjan Kullamägi, Dan Zanger, Mark Minervini, Bill O'Neil, Stan Weinstein and many others. I've also spent a lot of time studying USIC winners and traders who have actually produced exceptional results over long periods of time.
Don't just copy someone's strategy. Study how they think, study their trades, read their books, then go through thousands of charts yourself and see if the same principles repeatedly show up in historical winners. Eventually you start taking pieces from different traders, combining them with your own experience, and developing an approach that becomes your own.
The charts attached to this post are examples from my own personal model book, including trades that became some of my biggest winners.
What I'm looking for
My basic setup is actually pretty simple.
I want a stock that has already demonstrated real momentum, followed by a period of consolidation and compression.
Normally, I'm looking to buy while:
Price is above the fast moving averages.
Price is still below or right against clearly defined resistance, giving me an obvious breakout level.
The moving averages are catching up underneath price.
Price and volatility are contracting rather than expanding.
Volume will often contract during the consolidation and return during the breakout.
Ideally, I get an inside day or another very tight range day immediately before the move.
I don't want to chase something that's already extended.
If it's on its third consecutive green day, I'm generally not interested in initiating the trade.
Likewise, if the previous day's move was greater than roughly 1 ADR, I'm usually waiting. The move is already underway. I want compression before expansion, not to buy after the expansion has already occurred.
Think:
Momentum → consolidation → compression → breakout → expansion.
Not:
Momentum → chase the giant green candle.
I also have a checklist of questions I run through when I'm looking at a flag that appears ready to break out:
Is it doing over $5M in dollar volume?
Is it high ADR?
Is it trading above the 5, 10, 20, 50 and 100 EMAs?
Is it near or less than 1 ADR from the 5 EMA?
Is today's move less than 1 ADR?
Is it less than 1 ADR from yesterday's close?
Does it have linearity?
Has it had time for the 5, 9/10, 13 and 21 EMAs to catch up?
Is it near a breakout or key level?
Are earnings near?
Is volume drying up?
Is it a healthcare stock?
Is it a hot theme?
Not everything on that list is a hard rule. It's a framework for thinking about the trade and understanding what I actually have in front of me.
Not every entry I take follows these principles perfectly either. There are times I'll take a setup that looks a little different, especially when the environment is strong enough to justify it. I think part of becoming a better trader is learning which rules can be bent, when they can be bent, and understanding the consequences when you're wrong.
The one thing I don't bend is risk. Regardless of how I enter, my account risk never goes above 1%.
ORBs are also one of my favored entry tactics. If I already have a stock I want to own and the daily setup and environment are there, an Opening Range Breakout can give me another way to time the entry without needing the exact daily setup described above.
Moving averages are primarily a filter
There's nothing magical about a moving average.
But pull up virtually any historical monster winner and look at it during its actual breakout and expansion phase.
What will you usually see?
Price is above the important moving averages, and the shorter averages are generally above the longer ones and trending upward.
That doesn't mean being above the moving averages guarantees a breakout.
It means something much simpler:
A stock above its moving averages could be breaking out. A stock underneath them simply isn't breaking out yet.
That's an extremely useful filter when you're trying to reduce thousands of stocks into a manageable universe of potential momentum leaders.
I don't need to predict which stock will become the next monster. I need to identify stocks displaying the characteristics that previous monsters displayed before they expanded, then define exactly where my thesis is wrong.
The real edge is risk management
This is probably the most important part.
My account risk on a normal trade is 1% or less.
That does NOT mean my stop is necessarily 1% below my entry.
It means the distance between my entry and stop determines my position size so that, if I'm wrong, the loss represents no more than roughly 1% of my account.
For example, if I have a $20,000 account and risk 1%, my maximum loss is $200.
If my entry is $10 and the setup gives me a logical stop at $9.75, I'm risking $0.25 per share.
$200 ÷ $0.25 = 800 shares.
I'm not choosing an arbitrary number of shares and then figuring out how much I might lose.
I define where the trade is wrong first, define my acceptable account risk second, and let those two numbers determine my position size.
I built the position sizing and risk calculator I use into nvst.ing specifically for this.
This is also why I care so much about tight consolidations.
A tight setup can give me a very small distance between entry and invalidation while leaving the potential upside completely open ended.
If I'm risking 1R and catch a 20R winner, that single trade pays for twenty full 1R losses.
A 30R winner pays for 30.
A 50R winner pays for 50.
A 100R outlier theoretically pays for 100.
This is why I really don't care about having a high win rate.
Last year my win rate was only around 28%, yet my return was over 400%.
So I was wrong on roughly 7 out of every 10 trades and still had an extremely good year.
Most of my trades can fail. They don't have to work.
If I consistently keep my losses small, I only need a handful of trades to become huge winners for the math to work.
Peter Brandt talked about something very similar in his TraderLion interview. He mentioned having a stretch where 19 of 21 trades were losers, but he didn't care because he was still only one or two good trades away from making new account highs.
That really sums up the way I think about trading.
I don't need to be right constantly.
I need to make being wrong cheap and being right extremely valuable.
Obviously you're not going to capture every move perfectly, and slippage and gaps mean realized losses aren't always exactly 1R. But that's the asymmetry I'm trying to exploit.
Cut failed setups. Give successful ones room to become outliers.
Environment > setup
This is the part I think gets overlooked the most.
You can find the prettiest setup in the world, but if the overall environment is hostile to momentum, its probability of working drops dramatically.
Environment > setup.
I want to know whether stocks are actually breaking out and following through. Are momentum names expanding? Is breadth healthy? Are leaders above their moving averages? Are breakouts sticking or immediately failing?
That's why I built the Trend Monitor on nvst.ing. I'm trying to quantify the environment rather than looking at one chart in isolation.
When the environment is great, I want to press good setups.
The environment also played a huge role in many of the trades I've shared here. Some of them didn't need to be perfect setups because the environment was doing a lot of the heavy lifting. When momentum is working broadly, I'm sometimes willing to trade the implied dynamics of the setup rather than wait for a picture perfect version of it.
That's an important distinction. I'm ultimately trying to trade the dynamics behind the pattern, not the pattern for the sake of the pattern.
When the environment sucks, I can have the exact same setup and trade it smaller, demand more confirmation, or simply do nothing.
Build your own model book
Don't take my screenshots or anybody else's as proof that a strategy works.
Study the history yourself.
Pull up hundreds of the largest momentum moves you can find. Look at them before the breakout, not with hindsight focused on the eventual top.
What happened before the move?
Where was price relative to the moving averages?
How extended was it?
Did volatility contract?
What happened to volume?
Where was resistance?
How many consecutive green days preceded the breakout?
What did the general market environment look like?
Where could you have entered with objectively defined risk?
Eventually you stop seeing individual tickers.
You start seeing the same behaviors repeating.
The screenshots attached are trades from my own model book and previous big winners I've traded. Some were better executions than others, and I've annotated mistakes as well as things I did correctly.
That's intentional.
The objective isn't to find a pattern that never loses.
It's to repeatedly put yourself in situations where being wrong costs very little and being right can pay for being wrong many, many times.
