High momentum stocks are those that are capable of rising very fast in a short period of time. In most cases, these stocks can also crash unexpectedly and carry significant risks. When handled properly, however, momentum trading can be a rewarding method of profiting from the stock market.
Definition and Risks
Stocks are like humans in that they tend to have a specific disposition that is relatively consistent. Some stocks make slow and steady movements over time, while others advance rapidly on the way up and come crashing down in bad times. Stocks that move erratically are said to have high momentum. Such stocks can obviously make you a lot of money, but the losses can also be enormous. In most instances, the business prospects of the issuing firm are uncertain. Stocks of young companies that are trying an untested business model or established firms that are going turbulent times tend to carry a great deal of momentum on the way up as well as down. Due to the inherent risks, you should only commit a relatively small portion of your portfolio to such stocks.
There are two main ways of profiting from high momentum stocks. You can either catch an advancing stock early on or identify a beaten down stock that is poised to rebound. Momentum traders scan a large number of stocks and take a closer look at those which have advanced quickly or lost a great deal of their value in the recent past, perhaps over the last week or so. When picking stocks that have rapidly advanced and may continue to do so as they have attracted a great deal of new interest, compare their recent gains to historic trends. If such s stock tends to retreat after going up by 40 to 50 percent, for example, and has already gained close to 40 percent in the last few weeks, it may be too late to get on board. When trying to catch a rebound, stay away from firms with such insurmountable issues as debt crises, legal troubles or major scandals.
Cut Your Losses
If a momentum trade is going against you, get out. When trading high momentum stocks, it is especially important to close a losing position to contain the damage. Almost without exception, stocks that are capable of impressive upswings can crash with equal speed. The best way to limit your losses is to use a stop loss. Before purchasing a stock, decide at what point you will put an end to the agony if the stock price declines and place either a mental price limit, at which point you will sell the shares or enter such an order into your broker's database for automatic execution. Usually a loss of around 20 percent is the most you should tolerate in any particular trade.
Know the Issuer
Although momentum traders primarily focus on a stock's recent price movements, it is crucial to know what is causing the sharp moves. Once you identify a stock as a potential momentum trade, study the firm and understand the source of the up or down swings before you commit capital. Ensure that the recent gains were not due to an unfounded rumor or that the crash was not due to a continuing major problem. Once you purchase stock, continue to closely monitor the headlines and do not hesitate to sell if the news hints at an imminent turnaround of the favorable trend.
Hunkar Ozyasar is the former high-yield bond strategist for Deutsche Bank. He has been quoted in publications including "Financial Times" and the "Wall Street Journal." His book, "When Time Management Fails," is published in 12 countries while Ozyasar’s finance articles are featured on Nikkei, Japan’s premier financial news service. He holds a Master of Business Administration from Kellogg Graduate School.