A Highly Effective Momentum Indicator From MIT

From the Baltimore Clubhouse – In recent weeks, I’ve written that investors should look at the recent sell-off optimistically.

Bull markets have their fair share of corrections. This is one of them. So take advantage of the opportunity to buy good companies at a discount.

One thing to watch for are stocks that have showed momentum in recent years but are now temporarily down…

Many of those stocks are trading at deep discounts.

Momentum stocks are generally some of the biggest-gaining stocks on the market. That’s because many traders believe that a stock in motion stays in motion.

If it’s going up and up… what are the chances it’ll come down?

Of course, stock prices ebb and flow. But some stocks do seem to push higher longer than others.

It’s those stocks that momentum investors try to identify, hold and profit from over the long term.

Consider the performance of the iShares Edge MSCI USA Momentum Factor ETF (CBOE: MTUM) since its inception in 2013.

This ETF, or exchange-traded fund, tracks the performance of large cap and midcap stocks with significant liquidity that have seen a lot of price momentum.

According to MSCI’s methodology, those stocks are selected based on a momentum score determined by a stock’s six- and 12-month performance on a risk-adjusted basis.

The index then tracks roughly the top 30% of stocks with the highest momentum scores.

As of last week’s close, the ETF has delivered a 132.6% since inception.

Over the same period, the S&P 500 large cap and S&P 400 midcap indexes have delivered a 76.6% and 66.6% return, respectively.

As you can see, that’s a near twofold outperformance over the broader indexes. A deeper look into the stocks driving this index sheds some light. Below are the ETF’s top holdings and the one-year performance of each.

As you can see, most of these stocks – except for Intel (Nasdaq: INTC) – have at least doubled the S&P 500’s trailing 12-month performance of about 5.6%.

And we’re seeing it at the Club too… Chief Investment Strategist Alexander Green’s Momentum Alert has produced an average annualized return of 193.1% since its inception in 2001. Comparatively, during the same period, the S&P 500 has produced only a 6.6% annualized return.

Momentum stocks are easier to identify in hindsight. But there is a way to know which stocks will pick up steam before they do…

One signal that’s proven effective is high call options volume.

In 2006, researchers at MIT and the University of Illinois studied whether put-call ratios could forecast a stock’s future price.

Call options give the buyer the right to purchase the underlying stock at a fixed (strike) price. Puts give the buyer the right to sell an underlying stock at the option’s strike price.

The ratio of puts to calls can give traders a sense of whether overall sentiment is bullish or bearish – especially when the put-call ratio is extremely high or low.

Keep in mind that the greater the call volume, the lower the put-call ratio.

The study found that stocks with lower put-call ratios outperformed stocks with higher ratios – indicating that options volume can be used as a bull or bear signal for stocks.

But there’s more…

The study also found evidence that options markets with more informed traders show the greatest outperformance.

Outperformance of stock options was greater than that of index options, which suggests that traders with insider information on a particular stock make better trades than those betting on broad market trends.

In other words, options volume is not only an indication of short-term bullish or bearish sentiment, but possibly a telltale sign of insiders making bets on companies before nonpublic news gets announced.

As such, it could be a good way for investors to find tomorrow’s big momentum plays today.

Good investing,

Anthony

P.S. Chief Investment Strategist Alexander Green looks at indicators like this (and others) to find momentum plays. In fact, he’s found a way for you to pocket an average of up to $11,669 every week from his top momentum picks. To learn more, click here now.