Has a friend ever forced you to read a book? It happened to me and I was glad he did because it showed me a better momentum indicator (exponential regression) that we immediately added to the screener.
The book he forced me to read is: Stocks on the Move: Beating the Market with Hedge Fund Momentum Strategies by Andreas Clenow. It is a great book that is surprisingly easy and fun to read in spite of its somewhat intimidating title. Add it to your reading list you will definitely learn something.
A great trading strategy and better momentum – exponential regression
The book describes an interesting trading strategy that uses a different way of calculating share price momentum, to help you find good stocks that are moving up (stocks on the move).
Problem with existing momentum calculations
If you are looking for stocks that are moving up nice and smoothly there is a problem with the way momentum is normally calculated.
For example 6 months momentum is calculated as the current share price divided by the share price six months ago.
The following chart shows the problem with this calculation:
You do not want jumps like this when using momentum
When looking for a stock with good momentum you want to find one that is moving up smoothly, you do not want to see large jumps in the share price, for example because of a takeover offer.
A stock price that makes large jumps may not move up much more because the news is already priced in.
This is not nearly as good as a smoothly upward moving stock price due to every day interest by investors willing to buy the stock at a slightly higher price.
The better momentum calculation
To find stocks with a smoothly upward moving stock price you want to calculate the average daily percent increase in the stock price. To do this we use exponential regression.
For example, using exponential regression, you can calculate that over a 90 day period a stock price increased by 0.05% per day.
Then, if you assume there are 260 trading days in a year, theoretically the share price may go up 13.88% (0.05% to the power 260) over a year.
Keep in mind that we do not expect to make this return but it gives us an idea of how much the stock price has increased over the past 90 day if you extend this increase to a year.
You do not need to know all the math
Do not worry if the math looks intimidating, you do not need to know any of it to use this better momentum indicator to find investment ideas.
How well does it fit – Adjusted Slope
To get rid of companies with a large jump in share price (bad momentum) you want to make sure that the calculated daily price increase is as close as possible to the real daily increase in the stock price.
Luckily there is a value that allows us to do exactly that.
It is called R2 (the coefficient of determination) and it tells you how well the calculated daily stock price increase fits the real daily increase. If R2 is equal to 1 the real daily increase is equal to the calculated value and if it is close to zero the calculated value is not at all close to the real daily increase.
To see how well the daily stock price increase fits the actual share price movements is easy to calculate.
Simply multiply the calculated increase by the R2 value.
If the fit is good (close to 1) the calculated value will remain the same but if it is bad (R2 less than 1) the calculated share price increase will decrease.
In the screener we call the indicator (exponential regression x R2) the Adjusted Slope of the stock price.
How to find investment ideas using exponential regression?
If you would like to start using exponential regression to find investment ideas click here: exponential regression screener?
It works well if you are a value investor as it lets you avoid value traps.
Summary and conclusion
In summary the adjusted slope is a better momentum indicator you can use to identify companies with a stock price that is moving up smoothly. It does this by penalising companies with a stock price that has moved up in big jumps.
I am sure it is an indicator that will help you identify even more profitable investment ideas as it is available on all the, more than 22,000 companies, in the stock screener.
PS To get unlimited access to the adjusted slope as well as over 83 other ratios and indicators you can use to find investment ideas sign up for the screener, it costs less than an inexpensive lunch for two.
Why not sign up now (before you get distracted)? Simply click the following link: Screener join today