Trading Momentum Stocks
Momentum stocks are stocks that are moving rapidly in price, often upward and often without regard for fundamental valuations. In the U.S. there are several of these and all are well known to the investment community as being over priced and yet still not a good sell or short opportunity, or at least maybe not just yet.
Trading these stocks can be very lucrative based on the fact that the moves can be very large over the course of a month, a week or even a single trading day. But with great reward comes great risk, as the moves can equally lead to losses if you are on the wrong side of the trade.
Of the names that have recently been making the headlines stateside are companies such as Twitter, Tesla, Netflix, Facebook and plenty of others. Even Google might be considered a momentum stock due to its one way price action, though it is by no means as overvalued as its peers.
With the former names in mind, a stock such as Twitter is trading at 300 times its possible future earnings and the company has yet to make a profit. It had a market capitalisation of around US$10 billion at its IPO, which incidentally many people thought was already expensive, but it has since tripled in value without any fundamentals changing whatsoever.
Tesla motors, a maker of niche electric performance cars is expected to increase its current production from 20,000 vehicles to 40,000 vehicles in the next year. Yet it is worth more than 20 billion USD, not too far behind other car makers such as Fiat and Ford who make millions of vehicles per year. Currently Investors are paying nearly one million dollars per car represented by the market cap.
Netflix is adding good numbers of subscribers for its streaming movie services, but whether or not it can be as profitable as investors expect remains to be seen.
Clearly for all these companies, strong growth is being priced in. Those investing are looking to the future and paying some, or indeed a lot, for future growth, well in advance. Whether that growth will come or not is open to argument, but it is the one thing that keeps stocks at such very high prices, even when current business looks pitiful in comparison to the market cap of the company concerned.
Even though they are widely considered to be expensive, they just keep going up, or at the very least hold their value well. These selected stocks are exhibiting behavior that is not too different to stocks in the tech bubble at the end of 1999 that burst with spectacular results. At that time people would pay anything for shares regardless of cost simply because they were going up.
Taking the example of Twitter, which saw its share price rise from US$26 to US$74 in short order, even whilst most analysts put a price target of US$33 to US$40 on it at the top of their range. Why should this stock trade so high and with such a rapid price move? Is it time to get
in on the action and buy even though the price is ludicrously high, or is it time to short sell the stock and make money when it eventually falls to the ground, if it ever does? Well one of the reasons that Twitter rose so fast is due to the fact there were a large number of shorters already in the stock. Shorters borrow the stock and then sell it at what they think is a high price with a view to buying it back again when the price is lower. At that point they return the shares to the lender and keep the difference between the high selling price and the low buy back price.
Still things can go wrong and if the prices rise, shorters will need to pay the difference and be forced to buy at even higher prices in what is known as a short squeeze. With Twitter there were many shorters selling short at $50, expecting the price to drop. When it didn’t they were forced to buy back at $55 , $60 even $70.
At the same time buyers, those brave enough to get in on the action, were having a field day, seeing their shares rise to extraordinary levels. With the price rises comes hype and with the hype comes more price rises! Shorters just added to the shortage as they all became forced buyers at ever higher prices.
What made the situation worse was that there was a shortage of stock in the system. Twitter released just 70 million shares, just a small minority of the total stock available with the rest held by institutions. With 200 million subscribers it means if these subscribers want just one share each there is not enough to go around.
Since hitting a $74 high Twitter shares retreated following a downgrade by heavyweight ratings agency Morgan Stanley. Yet the shares still stabilized at around the $57 mark and whether new highs are yet to come remains to be seen.
When it comes to “investing” in these stocks, which are much more like a roulette wheel then any others, there are some things to watch. Check the short interest, which will detail the number of shares that have been borrowed and sold short. It could indicate extra-ordinary buy interest even at high prices as shorters are absolutely required to repurchase stock at some point. It just hinges on how much pain they can take if the price rockets higher. Most, redictably, will buy back to stop further losses and this can drive the stock higher. Look out for upgrades and downgrades news, as well as the general hype surrounding a stock. It will give you pause for thought before entering, or may allow you to profit from prices by buying at a high price and selling at an even higher one.
A look at the prior pricing action is also warranted. If the stock is showing signs of fatigue then it may be time to join the shorters, or to be cautious about entering on the buy side. You can certainly check fundamentals, but in the end this is immaterial in a momentum trade since there will usually be a shortage of stock and a high demand from buyers. This will be enough to propel the stock to higher levels regardless of the fundamental strength of the business and completely regardless any income etc.
A good way to proceed is to wet your appetite with a small trade. This will still enable you to profit quite well since the moves can be larger than most other stocks. However it will allow you to manage losses. Remember that much of the movement will occur out of hours in the form of gaps at the start or end of trading and so you will need to be generous with stop losses but also quite strict about them if they get hit. With the above in mind you should be able to reap benefits from some of the most volatile momentum stocks in the market regardless of their valuations.