Beer, Pork and Drugs at the New All Time High List

There is a great variety of industries at the all time high list – from discount US retailers to Chinese pork producers.  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.

The big variety at the all time high list is a healthy sign for the market. It shows confidence. In the end of the day, risk appetite plays a huge role for the near-term price action. The momentum approach could be extremely profitable if it is combined with proper risk management. A few times a year, the market just wants to go up and momentum stocks appreciate 20-50% in a month on less.

What is important to realize, is that most of the hot momentum stocks are just rented and at some point of time they will be sold. When everyone rushes for the exits at the same time, there is not enough liquidity to meet the supply. The difference between a great momentum investor and a good momentum investor is that the former knows where to sell and he’s willing to turn investments into trades.

How to manage a position

On August 23rd, I wrote a post: $ASYS – the anatomy of an earnings trade, where I described the catalysts behind $ASYS move. I finished the post with the following quote:

$ASYS is currently overextended and it is likely to experience a pullback, probably to a longer time-frame MA – 20 day or 50 day. Let see if the previous zone of resistance around $12-$13 will turn into support.”

This is exactly what happened. The stock retreated to its rising 20-day MA, where it built a proper base and continued to march higher.

In my previous post, a commenter asked me to explain my approach towards position management. I utilize four very simple rules:

1) I sell 1/2 of my position if it appreciates more than 15-20% above my entry point. For the other half, I raise my stop to break even. I want to make sure that that I protect at least part of my profits. I can always add more later when the stock sets up again.

2) I sell the whole position if it increases to a level of 25% above its relevant moving average. At this point I have no idea if the stock is going to continue higher. All I know is that it is extended and based on experience, profits should be  taken. Do all stocks tend to reverse after they reach 25% above their relevant MA. Absolutely not. They could go much higher. The point is that I don’t try to squeeze every cent out of a stock. I don’t have to in order to be consistently profitable.

3) I add 1/2 position on a 3% bounce from a relevant rising MA. The volume of that move has to be at least 120% of the average 50-day volume. Such price/volume action is a good indication of strong risk appetite for the stock.

4) Sell if the stock violates the low of the first day it closed below its relevant MA. The last condition is applied only if I am in a profitable position. If the stock turns against me immediately after I buy it, I make sure to keep my losses to 5 – 8%. When the average size of my winners is 2-3 times bigger than the average size of my losing trades, I can afford to be wrong 60% of the time and still make money.

The Proper Use of Moving Averages

Every stock has its own character. Some tend to keep their 5 day MA during the bigger part of their uptrend, others tend to keep their rising 10, 20 or 50 day MAs. The shorter the MA, the stronger the demand for the underlying stock.

There is nothing magical about the major moving averages. If they worked a few times as a support in the recent past, a large number of market participants start to believe that those same levels will work again. When enough people act on their beliefs, their expectations turn into self fulfilling prophecies and the stock bounces again from the same moving average.

Why such declines and bounces occur? Many market participants are reluctant to buy new highs or stocks that are extended from their bases. The next logical buy point is a bounce from a major moving average. Remark that I mentioned a Bounce. Today I noticed many people on the StockTwits stream to blindly buy stocks that were close to their 20 and 50-day SMAs. Everyone has his own approach. I just think that this one hides too many underwater rocks. Those MAs are a potential zone of support, not a sure thing.

Institutions and market makers are well aware of the fact that many market participants tend to put their stop losses right below the 5,10, 20 or 50-day MAs of the stocks they own. This is why, it is not rare to see a stock to dip intraday below a major MA. Such dip shakes the weak hands off and the stock resumes higher. I am also using the major MAs as a stop, but I added a few extra conditions:

– the stock closes below a major MA that has played the role of support during the recent uptrend;

– an exit signal is given, when the stock penetrates the low of the day on which the stock closed below the relevant MA.

What is the logic behind this exit approach? A close below a major MA doesn’t signify the end of a trend. It just signals change in the pace of growth and the potential beginning of the new base. Exiting at the above mentioned signal makes sure that your capital is not locked in stocks that will move in a range for a while. With other words, you make sure that your capital is allocated to positions that move in the desired direction and move fast.

Last week, I mentioned that I am eying one of the StockTwits 50 stocks – $CTXS, to pullback to its rising 20 day MA before I consider entering it. I would never buy a stock just because it has declined to its rising 5, 10, 20 or 50 day SMA. I always wait first for a 3% bounce on above the average volume, before I commit any capital.