"An investment in knowledge pays the best interest."
Newton 's first law of motion states that An object at rest stays at rest and an object in motion stays in motion with the same speed and in the same direction unless acted upon by an unbalanced force. Investors have been using this concept to buy and sell stocks for years. In this post, we'll look at a simple way to use momentum for investment purposes.
Translating Newton first law in "investment" terms, simply means to capture gains by staying in securities that are in a continuance trend, and selling those who aren't. Simple enough! How can we measure momentum ? Well there different indicators out there that measures it , such as moving averages crossovers and RSI. Personally, I like to use the Rate of Change (ROC) indicator.
The ROC measures the percentage change between the most recent price and the price "n" periods in the past. A reading above 0 indicates positive momentum, while a reading below 0 indicates negative momentum.
So how can you use the ROC to find assets that are in positive momentum ? From a passive investor point of view, I like to see the bigger picture , so instead of using a intraday or daily time frame, we'll use monthly time frame. For the ROC , we can use a range from 6 to 12 months. Research has shown that using a 12 months look back period , provide us with the best return.
Here's the strategy ' rules :
Using the ROC of the past 12 month [ROC(12)] :
BUY if ROC > 0
SELL if ROC < 0
Let's look at the result who applied on the SP 500 ( from Oct 1982 till now )
Return : 149.80 %
# Trades : 15
Max DD : 32.07 %
Profitability : 66.67 %
We also get similar results when testing this on other indices. Notice how this simple system avoided the almost all bear markets.
As you can see , this ROC strategy is simple , but very powerful . Investors can use the ROC to identify trending securities. What will be the results if we apply this on a basket of stocks or sector ETFs? We'll find out in the next post.