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.
Lions Gate Entertainment (LGF), up 98% on the year, is in a similar position as GameStop, although the break below the trendline has unfolded in a much slower fashion. With LGF at this level, traders should take the Hunger Games hype with a grain of salt.
Another momentum stock that is teetering on the abyss is Best Buy (BBY). After defying all gravity — and logic — with its 233% year-to-date gain, BBY is approaching territory that signals a potential breakdown is at hand.
On the other side of the coin, this same use of trendlines shows a number of momentum stocks that could have additional upside.
Netflix (NFLX) is the only chart pictured, but Pandora (P), Micron Technology (MU) and TripAdvisor (TRIP) are all among this year’s big winners whose uptrends remain firmly intact.
In these cases, the lower trendlines serve as a clear reference point where longs can set their stops.
Not everyone believes in the value of technical analysis, but it’s particularly useful among momentum stocks because traditional metrics such as fundamentals and valuations are out the window.
What’s the appropriate valuation for a company with a game-changing technology that’s currently losing money, such as the Teslas and Twitters (TWTR) of the world? Not even the professionals know for sure.
But what is knowable is price — and that’s where the charts are the most valuable.
Momentum stocks represent the deep end of the pool for individual investors, and every possible tool helps. Over time, using these trendlines can prove invaluable in navigating this fast-moving area of the market.
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.