Momentum stocks are a dangerous game. As quickly as they can make you money, they can empty your trading account and leave you beaten up and bewildered. While the answer for many traders is simply to avoid these momentum stocks, there’s a way to participate while still keeping a lid on the downside risk.
The answer, of course, is to use stops — that much is obvious.
But how do you set the stops, and how can you tell when the momentum story is broken for good?
The answer lies in the charts — specifically, the lower trendline. This line not only can serve as a reference point for setting hard stops, but it can also shown when bottom-fishing is unwise. This latter consideration is key, because a former momentum stock that is down 20% or more in a short period invariably attracts traders who were left out the first time around.
Don’t fall into this trap.
While avoiding these broken-down momentum stocks might cause you to miss out on gains here and there, it’s an easy way to give yourself downside protection.
A number of the market’s current “hot stocks” offer some prime illustrations of how trendlines can be used as an indicator of when the momentum story is over.
Tesla Motors (TSLA), for example, chalked up a gain of 420% from April through September, but it has since been hit for a loss of more than 37% after a series of widely reported engine fires. The area in the circle shows the breakdown below the trendline signaled the end of Tesla’s momentum story, and the failure of the stock to retake the line was a confirmation.
In short: Traders had a clear signal of when it was time to get out of TSLA stock.
Another example is the Permian Basin fracking company Pioneer Drilling (PXD). Pioneer doubled in its April-October rally, but — in classic “story stock” fashion — its shares moved to an elevated valuation of about 40 times forward earnings.
PXD has since broken the trendlines it established during the rally, indicating that it is in extremely vulnerable territory here. There might be about 7% of upside left, but with the potential for 16.5% downside to its breakout point of $158, the risk-reward just isn’t there.
Similarly, GameStop’s (GME) break below its first lower trendline was a warning that it was time to exit, and today’s downdraft is a confirmation that this momentum story is over. With the stock now broken down, any attempt to play a counter-trend move could prove dangerous.