Momentum Monday – More Rotations

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The momentum from the previous week fizzled a bit with the start of the earnings season. It is still very early to judge, but so far we can say that bank earnings have been accepted very favorably and some of the tech earnings not so much. Look at the fade in NFLX and the breakdown in TEAM, for example. 

The same two major themes continue to persist in the market:

  1. Homebuilders and building material stocks are shining and are basically the new momentum stocks. Many of them are already up 10-20% for the past couple of months. 
  2. Many enterprise software stocks continue to decline due to fear of rich valuation. The Wework debacle really scared many investors and it has reset the valuations not only in the private but also in the public world.

P.S. You can now subscribe to my private Twitter feed and follow my options ideas and commentary in real time. You don’t want to miss out on this opportunity.

Swing vs Position Trading

The purpose of swing trading to capture hundreds of 5-20% short-term gains within a year. Short-term means 2-10 days. To capture two hundred 5-20% gainers, we often might need to take four hundred trades because half of them will be losers. The trick is to keep the size of losers small – up to 3-4%.

When we apply an options filter on top of swing trading, its purpose becomes trying to capture hundreds of 100%-1000% short-term gains while risking 0.5% to 2% of our capital on every single one of them. Obviously, about half of them will be losers. When it comes to short-term calls or puts, the risk is often the entire premium.

A typical swing trade lasts two to 10 trading days. There are various swing trade setups. I am not going to go into details here but in most cases we are looking for some form of contraction in an established trend.

Here’s a recent trade we took. LULU had a big earnings breakouts to new 52wk highs followed by a pullback to its 50-day moving average where it found support. As soon it went above its 20-day EMA and started to consolidate in a tight range, I tweeted the following:

Obviously, you play the same setup with a stock. Buying it in anticipation of a breakout, risking 3 points to potentially make 5 to 10 points. We went with a short-term call option because our risk was better defined (the entire premium) and out upside potential was bigger. The same weekly call that was $1 when I tweeted that message was trading near $7 on its expiration day. Granted, I took profits much earlier (at $3) which is a matter of entirely different discussion (not optimal trade management) but the moral of the story is that short-term options often offer much better risk vs reward than swing stock trades.

Position trading is about capturing bigger moves: 10% to 50% moves (sometimes higher) that require holding a position for multiple weeks, even months. In my experience there are three types of solid position trade setups:

  1. Finding a theme in the market and exploiting it. There are several distinct themes every year in market and figuring them out in time can be very profitable. Themes persists and can last multiple weeks, sometimes multiple months. For example, two themes have persisted in the past couple of months: homebuilding stocks have been rising as a group and High-momentum software stocks have been demolished due to fear of unsustainable valuation. 
  2. Huge-volume breakout to new 50-day high. I am talking 5x, 10x, 20x and higher than the average daily volume that leads to a 10%+ daily gain. There’s typically a clear catalyst behind the move – an earnings report, FDA approval, new contract, etc. Many of the best performing stocks in any given year start their moves with a huge-volume earnings breakout. Finding them is not hard. Riding them is what’s the biggest challenge for many because short-term 10-20% gains are too tempting for many and they never give their stocks a chance to double. Also, going through deep 20% drawdown is too scary for most people and bigger gains in individual stocks require bigger drawdowns. 
  3. Buying after a major market correction: 15-20% correction for the S&P 500 or the Nasdaq 100. Two types of stocks outperform significantly after a major market correction:

a) The stocks that go hit the worst – typically recent IPOs with small float that went down 50-90% during the correction. Some of these stocks will double and triple within a quarter of the correction bottom.

b) The first high-growth stocks that break out to new 52-week highs right after the correction. 

We can apply a simple options filter to position trades as well. Since position trades often last multiple week, they require buying longer-term options (at least 2-3-month in duration). Obviously, those options are much more expensive than the weeklies because they have a lot more time value in them. At the end of the day, going with a stock or an option comes down to risk vs reward. If you need to risk 4 points in a stock to potentially make 12 points and you need to pay $6 for a long-term option to potentially make 12, you are better off going with the stock because it offers better risk vs reward (and it is more liquid).

When done correctly, swing trading can compound capital much faster than position trading because there are many more great swing trade opportunities than position trade opportunities in any given year. The challenge for many is that swing trading is a lot more demanding in terms of required efforts, preparation, skills, and time.

Momentum Monday – The Bulls Are Still Alive

The charts on Momentum Monday are powered by MarketSmith

There was an interim trade deal with China on Friday. I am sure this is not the end of the soap opera but for now it is enough for the market to rally. Obviously, the candle on Friday is not particularly bullish if it is followed by more relentless selling on Monday but we are certainly seeing an improvement in price action and market breadth. The large-cap market indexes are back above their 50-day moving averages. The 52-week high list is growing and it is not dominated by REITs and defensive stocks only. On the contrary, we are seeing various sectors represented – semiconductors, electronic equipment, biotech, software, service, retailers, restaurants. The Fed is expanding its balance sheet again and companies are buying back their shares at near record levels. All those factors might be enough to improve market sentiment and lead to higher prices. And when it comes to price action, higher prices have the uncanny ability to attract sidelined cash.

Keep in mind that the next earnings season starts next week with a bunch of financials scheduled to report. As always, earnings season will create many new trends and will provide an additional clue about the current market sentiment – there’s no better measure of risk appetite than the market reaction to earnings.

P.S. You can now subscribe to my private Twitter feed and follow my options ideas and commentary in real time. You don’t want to miss on this opportunity.

Also – Check out my trading books. They are super practical, packed with actionable information that can be put to use right away:

Swing Trading with options – How to Trade Big Trends for Big Profits

Top 10 Trading Setups – How to find them, how to trade them, how to make money with them.

The 5 Secrets To Highly Profitable Swing Trading