Long-term investors usually look for stocks that are of high intrinsic value but low cost. So the idea of buying stocks with high PE ratios that are rapidly rising in price might seem scary.
But if you are buying a “momentum stock” and if you are looking to trade it rather than hold it long-term, buying even the most extremely overvalued stocks can sometimes be the right thing to do.
So how do you know if a particular stock is a “momentum stock”? And how do you protect yourself from the inevitable crashes that these stocks often have?
How to Identify Momentum Stocks
Momentum stocks are stocks that have recently broken out and are rising quickly. They often exhibit a kind of self-reinforcing “mania” in which they keep moving higher because they keep moving higher.
When momentum stocks appear, analysts on TV will often say that they are in a bubble and are going to crash any minute. But no matter how many experts tell people not to buy them, they keep going up anyway.
However, it’s important to distinguish these stocks from ones that just happen to be going up at the moment. Momentum stocks have strong upward momentum that is likely to last for a while. They are not merely rallying in the moment.
So here’s six characteristics of momentum stocks. If a stock has most or all of these characteristics, it’s probably a momentum stock.
- It just made a new all-time high or at least a new 50-week high.
- Volume recently increased by 5x or more.
- The price is above its 50-day SMA.
- Its 50-day SMA has crossed its 200-day SMA, creating a “golden cross”.
- It has a market cap of $5 billion or less.
- The float is 25% or less of the shares outstanding.
Here’s an example of a momentum stock from June of 2017:
Autohome, Inc. is the owner of a web-platform that gives Chinese consumers information about cars.
In January, its price produced a golden cross. Then in June, the price moved above the 50-day EMA and produced a new all-time high. At the same time, volume increased from 500,000 to over 4 million. This is 8x the normal volume.
In addition, at the time this surge took place, its market cap was only around $4.1 billion.
So this stock exhibited four of the five characteristics of a momentum stock.
Now let’s look at what has happened since June.
Anyone who bought this stock would have made a nice profit by now.
But since it’s gone up that fast, isn’t it going to crash?
How to Protect Yourself When Trading Momentum Stocks
It’s true that momentum stocks often crash just as quickly as they go up. So in order to protect yourself, you should always place a stop-loss at the 10-day EMA.
Then, after the stock moves up, simply “trail” your stop by moving it up to the new location of the 10 EMA. That way, you lock in your profits without risking too much.
If you get stopped out, it’s usually not a good idea to reenter the trade. And it’s even worse to try to “buy the dip” on a momentum stock. If the mania is over and retail investors are coming to their senses, the stock can fall pretty quickly. So it’s best to just take what profits you have and run.
There are always new momentum stocks forming. So you should have another chance again soon.
Long-term investors will tell you not to buy stocks that are overvalued and hyped-up. But sometimes trading these stocks can be a good idea. Follow these tips to profit from them while also keeping yourself safe from their inevitable crashes.