Today I will discuss momentum stocks, and how you can play them with great success. The first thing you should understand is that momentum stocks display rapidly rising price appreciation in a short period. Catch the wave up, and you can make some awesome returns, but if you enter the stock near its pinnacle, you could easily be wiped out.
Let’s take a look at one of my favorite tech stocks, SanDisk Corp. (NASDAQ/SNDK) — the world’s largest flash storage card product manufacturer. You know the product. You see it in everything, like digital cameras, camcorders, handhelds, and computers. The stock has been on my buy list since December 2001. I initiated coverage when the stock was trading at a mere $5.32. The stock is currently up over 1,000% and continues to have good upside potential.
If you own a momentum stock that has entered profitable territory, the first thing you should do is take some profits off the table. For instance, if you bought SanDisk at $10, you should take some profits when it trades at $20. By taking profits as the stock goes up, you guard against a potential selloff in the stock. Locking in trading profits always makes sense, especially when a stock surges on buying momentum.
Now take a look at SNDK from mid-August to the present. The stock traded at the mid-$30 range in mid-August and has steadily moved up to the $50 range in October. But positive news regarding the flash memory industry in late October had investors buying. The stock surged from $46.33 on October 20 to a high of $65.49 on November 4, a gain of $19.16, or 41.35% in only 11 days. Momentum is taking hold of the stock and driving it. But, given the strong surge, the stock has become technically overbought and subject to some profit taking.
When watching momentum stocks, you should take a decline in volume on the buy side as a hint that the stock may be due for a pullback, which did occur with SNDK when it dropped below $58 on November 10. That is a drop of 12% from its high, and, technically, it could signal more weakness ahead. When trading momentum stocks, you need to get in as early as possible and watch the buying volume. As long as there are more buyers than sellers, then there is a good chance you will see the stock rise. When the stock surges rapidly as in the case of SNDK, you need to take some profits. If you don’t, set a stop buy to protect the downside. Alternatively, you could establish a simple Put Hedge by buying Put options on SNDK. Should the stock decline, your Puts will increase in value and help to offset some of the losses from your position.
So, the next time you trade a momentum stock, following some of these basic risk management rules will allow you to become a more profitable trader.