Screening stocks for momentum and mean reversion strategies

Screening stocks for momentum and mean reversion strategies

In the previous post, we covered two distinct categories of strategies. Now, let’s explore the process of screening stocks for these strategies.

Not every stock is suitable for a particular strategy. The challenge lies in the fact that certain strategies yield positive results with specific stocks, while they may not be effective with others. Therefore, it is important to choose stocks based on our strategy.

To accomplish this, we will initially focus on two aspects, and gradually incorporate additional factors as we progress.

What is stock float?

The term “float” refers to the number of shares of a company’s stock that are available for public trading.

It represents the total number of shares outstanding minus any restricted shares held by insiders, such as company executives or institutional investors.

Put simply, the float refers to the number of shares available for trading on the market.

The float is an important concept because it can influence the liquidity and volatility of a stock.

A stock with a smaller float tends to have less liquidity, meaning there are fewer shares available for trading. As a result, even a relatively small buy or sell order can have a significant impact on the stock’s price.

This can lead to increased price volatility, as supply and demand imbalances are more pronounced in stocks with a smaller float.

Conversely, a stock with a larger float tends to have more liquidity, as there are a greater number of shares available for trading. This can result in smoother price movements and less volatility since larger buy or sell orders are less likely to cause drastic price fluctuations.

Example:

As an example, consider two companies: ABC and XYZ.

Furthermore, Company ABC has a float of 1 million shares, indicating that there are 1 million shares available for trading on the market that individuals can buy and sell.

And Company XYZ boasts a float of 1 billion shares, and both companies are currently trading at a price of $10 per share.

If someone intends to purchase all the shares available for trading on the market for ABC, they would need to spend $10 million. This calculation is derived by multiplying the number of shares, which is 1 million, by the price per share, which is $10.

If someone intends to replicate the same approach with Company XYZ and purchase all the shares available for trading on the market, which amounts to one billion shares, it would cost them a staggering $10 billion.

Given the considerable contrast between $10 million and $10 billion, it is indeed a significant difference. Now, let’s consider which company, out of the two mentioned, is more likely to experience a sharp movement or significant price increase if news emerges or if a few buyers enter the market.

Based on their respective floats, Company ABC, with a float of 1 million shares, is more likely to undergo a sharp movement compared to Company XYZ, which has a float of 1 billion shares.

Since Company ABC has a smaller float, it is relatively less liquid, and need less money to move, making it more susceptible to significant price swings in response to news or a surge in buying activity.

Conversely, Company XYZ, with its larger float, may experience less drastic price fluctuations due to a higher liquidity level and it needs $10 Billion or huge amount of money to make it move.

Now, let’s have another example.

Suppose there are rumors circulating about Stock ABC, suggesting that they may have a promising development on the horizon. Consequently, the price of the stock begins to rise. Why does this happen?

When a stock has a high float, it typically requires a large number of participants to believe in the legitimacy of the rumor and actively buy the stock to drive its price up. Consequently, a large float may hinder the stock from experiencing a significant surge.

Conversely, when a stock has a low float, it doesn’t require as many buyers to generate a notable impact and propel the stock’s price higher. Therefore, a stock with a low float is more likely to undergo a surge. This explains why Stock ABC, with its smaller float, was able to rise in response to the rumors.

If you are implementing a momentum strategy, it would be preferable to focus on stocks with a low float. This is because you are seeking stocks that can move in a particular direction more readily. With a low float, it takes fewer participants to generate significant price movement, increasing the likelihood of capturing momentum and achieving desired trading outcomes.

Individuals who engage in frequent pump-and-dump schemes actively seek out low float stocks. This is because low float stocks allow them to rapidly drive up the price and swiftly exit their positions.

You can find metrics such as float and others by visiting finviz or yahoo finance.

shares outstanding

Shares outstanding refers to the total quantity of shares available in a company, while shares float represents the number of shares actively traded on the market.

Low float is for momentum strategies and high float for mean reverting strategies.

While it is true that high float stocks generally demonstrate mean-reverting behavior and low float stocks often exhibit momentum behavior, there are instances where high float stocks can also display momentum behavior and low float stocks can show mean-reverting behavior. However, it is generally more likely for low float stocks to show momentum and high float stocks to exhibit mean reversion behavior. more probability

In trading you want the probability to be in your side.

If you understand that low float stocks have a higher likelihood of generating profits with momentum strategies, why would you choose to pursue a high float stock with lower probability?

What is institutional ownership?

Institutional ownership refers to the percentage of a company’s shares that are held by institutional investors, such as mutual funds, banks, pension funds, insurance companies, and investment firms.

There are stocks that institutions hold in high regard, investing a substantial amount of capital and acquiring a significant number of shares. Conversely, there are stocks that institutions choose not to purchase.

This holds significant importance as we have gained knowledge from observing how different players employ distinct approaches in the game. Consequently, it is crucial to develop varied strategies tailored to the players involved when dealing with specific stocks.

Example:

Suppose you check a stock like Meta and review its institutional ownership, which stands at 75%. This indicates that institutions hold ownership of 75% of the stock’s float.

institutional ownership of a stock

You are aware of how institutions engage in trading. When a stock’s value increases, they tend to sell off some of their shares and allocate the funds to undervalued stocks. Conversely, when a stock’s value decreases, they take the opportunity to buy more shares since this allows them to acquire larger quantities without significantly impacting the price.

Having this understanding, it becomes challenging to implement momentum strategies for stocks with significant institutional ownership.

As the stock price rises, institutions tend to sell off their shares, and when the price declines, they buy more. Institutions prefer to purchase a large number of shares, so they refrain from buying as the price is increasing because their actions would drive the price up and limit the quantity of shares they can acquire.

Institutions typically take positions against market trends, as this enables them to accumulate a substantial number of shares gradually.

Hence, institutions are present to provide support for the stock’s price during declines and act as resistance when it is rising. As a result, the stock consistently undergoes upward and downward movements, displaying a mean reversion behavior in response to changes in price.

Therefore, stocks with higher institutional ownership are more suitable for mean reverting strategies.

Now, with low institutional ownership indicating higher participation from retail traders like us, what does this reveal about their trading behavior?

As retail traders, we tend to differ from institutions in terms of our trading behavior. Unlike institutions, we typically do not purchase large quantities of shares, and we are more inclined towards momentum trading.

We enjoy chasing price movements, following upward trends. our trading behavior can sometimes contribute to the formation of bubbles or engage in pump-and-dump schemes.

Therefore, when you observe low institutional ownership in a stock, it becomes favorable for implementing any type of momentum strategy. Hence, if you are engaging in a momentum strategy, you would prefer low institutional ownership in the stock.

As mentioned earlier, stocks with institutional ownership are more inclined to exhibit mean reverting behavior, although there are instances where they can also display momentum characteristics.

Conclusion

To implement a momentum strategy, it is preferable to select stocks with low institutional ownership and a low float. On the other hand, for a mean reverting strategy, it is advantageous to choose stocks with high institutional ownership and a high float.

Regardless of having a cutting-edge strategy, it is essential to carefully consider the stock you choose to trade with that strategy. Failure to do so can significantly impact the effectiveness and success of the strategy. Because some strategies only work with some stocks.

To identify the optimal stock for your trading strategy, it is essential to conduct a screening process. This practice involves systematically narrowing down the vast array of available symbols to pinpoint the most suitable one that aligns with and complements your strategy effectively.

Among the screeners I have extensively tested, finviz and TradingView stand out as providers of some of the most impressive screening tools available.

Check out this video by bloom, about how to use screeners.