The psychological difficulties behind buying momentum stocks

A few weeks ago, I received an email from a reader, describing how he is having troubles buying momentum stocks. This is an excerpt from the email:

My question is HOW TO INFLUENCE MYSELF in order to get a little bit in the flow
of MOMENTUM, as well as to try to enter positions @breakout.
Lately the $indu was running almost 12 days consecutive (big momentum) but I
was paralysed. I just looked at it , and could not jump on.

I believe all traders have experienced fear at some point in their career. I am not a psychologist or neurobiologist and therefore I cannot give a professional assesment of the problem, but I could certainly look at it from an experience point of view. I have been there, I have done that and I have my theory that explains the issue.

This is what I answered. Feel free to chime in and share your perspective on the topic.

There is one simple reason why you are afraid to enter breakouts in momentum stocks – You don’t trust this method. You don’t trust it either because you recently had bad experience with it or you don’t have enough experience with it in general. If you don’t feel comfortable with certain approach, then either the approach is not suited for your personality or you haven’t spent enough time learning the approach.

There could be one more reason – your position size might be too big for your risk profile. Just decrease the size of your position until you feel comfortable.

You need to learn to accept losses as part of the game. Everyone has them. Many of the most successful traders are right only 30-40% of the time, but the size of the winners is much bigger than the size of the losers. If you define your loss in advance and accept it, you will feel much more confident in your decision making. For example, let’s assume that you don’t mind that you could lose $500 on a trade. If your buy point is at $45 and your stop is at $40, then you can afford to buy $500:$5 = 100 shares. If the stock declines to $40 and you get stopped, $500 is the max amount that you will lose.

Before you begin to win big, you need to learn to lose the right way. Have an exit plan before you open a position and know where your stop is and why it is there. From there, you could just ride the trend.

What Happens when Momentum slows down

Everyone is excited about the opportunities that momentum stocks bring when they are moving up. Unusual price moves lead to a conversation and boost risk appetite. But what happens when the momentum suddenly deccelerates or it just disappears? Many of the momentum stocks are parabolic. They move fast on the upside and they move even faster on the downside.

So what happens at the top? The stock goes significantly above its relevant MA, where it is very vulnerable to a sell off. It is not rare to see an exhaustion gap. The stock gaps up, runs during the first hour and then reverses intra-day. The demand suddenly vaporizes and with each point lower the supply increases as stops are taken one after another. The stock quickly breaks down below its relevant MA.

In my experience, there are two basic scenarios after a relevant moving average is broken. By relevant MA, I mean the MA that served as a support during the uptrend move of the stock.

Scenario 1: There is a wide-range one-three days sell off, followed by a significant reduction in the daily range and sidewise consolidation. The stock finds support at a longer-term rising MA – 20 or 50-day sma. This is a healthy behavior. Many market participants are reluctant to buy stocks that are extended from their base and patiently wait for another base to build before they commit any capital. A good illustration of Scenario 1 could currently be  found in $VHC, which has been a regular member of the StockTwits 50 list since its public introduction. The stock went from 6 to 20 in less than 6 weeks. Then it broke below its 10-day MA, which has been a level of support during the uptrend. It consolidated for two weeks as it found buyers above its rising 20-day MA. The stock seems ready to continue its move. Stop below $15.20.

Scenario 2: the stock slices through its relevant MA and then it quickly bounces from a longer-term MA, without spending any time in consolidation. Sometimes such bounces offer quick intra-day profit opportunities, but in general they are prone to a failure, especially if the stock doesn’t manage to clear the previous high.

Ecopetrol is Approaching a New All Time High

Ecopetrol is a Colombia based oil and gas exploration company. $EC is up 94% ytd and it has been a regular member of the StockTwits 50 list. As the market averages were moving in a range during the summer, $EC broke out to a new all time high in July. Since then it has been finding support above its rising 20-day MA, which is indicative of strong institutional interest. It is certainly worth it to pay attention to stocks with high relative strength.

The stock has recently accelerated its upside move and it looks like the 10-day might be the new relevant MA. $EC is within 1% of its all time high price level. Such acceleration in slope is usually a sign of increased risk appetite or the beginning of a blow off top. I am willing to take the risk here  and go long with a stop at 45.50.

Reasons to be bullish, Reasons to be cautious

Yesterday I had an opportunity to discuss StockTwits 50 and Momentum with Howard Lindzon. In the end of the conversation, I let myself to be lured in the intellectual sophistication of macro and outlined the galloping commodity futures as a reason for a potential market selloff. Honestly, this was a dumb thesis. The market could decline for many reasons, but macro themes should be the last thing in the decision making process of the momentum investor. Price action and intermediate catalysts are what matter. Short-term price trends are fueled by momentum, medium-term price trends are fed by earnings related catalysts, long-term price trends are sustained by social and business trends.

Where the stock market is going is anyone’s guess. I am not in the forecasting business. Let’s objectively take a look at some reasons to be still bullish and reasons to be extremely cautious:

Reasons to be bullish:

– The breadth is great; There is a large number of stocks from different industries making new 52-week highs;

– Sector Rotation from Technology to Basic Materials, which could keep this market going for awhile;

– Many new stocks are setting up good risk/reward opportunities;

Reasons to be cautious:

– It is still a renters’ market. Even the slightest wrong step is severely punished. (refer to $EQIX and the cloud computing space from last week);

– Junkie, high beta, Chinese burritos are making 30-40% runs in a week;

– The market laws require a massive short squeeze, just before the next leg down.

“Good judgement comes from experience and experience comes from bad judgement” – Barry Le Platner