This past week many market players were intently focused on the wild action in cannabis stock Tilray Inc. (TLRY) , which was up around 300% during the week, and on many of the smaller stocks in the sector, such as New Age Beverages Corp. (NBEV) , that made even bigger moves.
When there is wild trading in a sector it always brings out pundits who will scoff at the action and inform us that the action is not justified and won't last. If you are trading these stocks correctly, you already know that fact. That is not relevant information to those who are looking for profitable trades. They are very high risk/high return situations and require a much different approach than a normal investment.
The first rule of trading super-momentum stocks is to understand and embrace the idea that the shot skyward is just temporary. They will crash and burn, just like the Internet bubble did in 2000 and the crypto/blockchain frenzy did earlier this year.
When the crypto/blockchain bubble occurred there were dozens of so-called experts predicting that Riot Blockchain Inc. (RIOT) would reverse and give back its five-fold move. Very few of these experts shorted the stock since it was difficult to find shares to borrow, but making such predictions is an easy call for pundits who want to establish their great predictive abilities.
The nature of super-momentum stocks is they have a very limited life span. It is highly likely that Tilray will see a major decline in the near future and those who hold on to its share will lose substantial money. However, that is not a good reason to avoid trading Tilray or other super-momentum names.
To remove the fear involved in trading super-momentum stocks, the key step is to control your risk. When you set a limit on how big your ultimate loss can be, then you have removed the fear of the unknown. You must know what the cost of being wrong will be so you can deal with it emotionally. You are more likely to be fearful when you think of a trade in the abstract and consider how much money some people are likely to lose.
In many cases option strategies are the best way to control risk, but sometimes the premiums are just too high to make it work well. If you simply trade the stock the big risk comes from overnight exposure. There isn't any way to protect yourself from a large gap-down open, but that also is where the big opportunity also arises. Trying to find entry into a stock that gaps up big can be extremely frustrating if you are on the sidelines.
Sometimes the best way to control risk in such trades is to be ready for a complete loss of capital. If you are mentally prepared to lose the entire amount of your trade then it changes the dynamic of the situation. It is more like a lottery ticket with much better odds, and that requires a totally different way of thinking compared to a regular investment.
Once you have addressed the issue of risk, the next issue to confront is that you can't think of this situation like you would a regular investment. It is a waste of time to figure out valuation based on tradition metrics. All week long there were comparisons of Tilray's market capitalization to other major companies to show how ludicrous it was. That information doesn't help you trade the stock. Ironically that sort of fear-mongering often results in even more upside for a stock as traders use it to find new entry points and help create fresh momentum
It is important to think about super-momentum trading more like a game than an investment in a company. You are trading the emotions of other traders more than anything else. It is primarily a bet on psychology, and that is why it can be such an entertaining endeavor.
I often liken the trading of super-momentum stocks to a Ponzi scheme because the key to successful trades is being able to gauge to what extent buyers will continue to pay higher and higher prices. One thing that often helps a crazy stock to go even higher is that the traders have a gambling mindset. They will buy a Tilray at a very extended price because it is just a short-term gamble and they are not afraid of suffering a massive loss. It is entertainment just like a game of blackjack or a slot machine. When you know your potential loss you are more likely to take much higher risk.
The most important element to trading super-momentum stocks is that you have the right mindset. Forget what you know about investing and think of this in very different terms. This is not the situation in which you try to be a Warren Buffett. You want to get in and get out. When you have a good gain, you don't let it slip away. You take some partial profits. You don't worry about selling the exact top. You can always jump back in as the situation develops further.
I often have found that I do best when I take a gain too early and then look for another chance to trade the stock. You must think about each trade separately and can't let your previous cost basis influence your thinking. Many traders can't stand the idea of buying back a stock at a higher price after they sold it, but that should be totally irrelevant if the setup is there.
The essence of trading super-momentum stocks is to control risk and to think in terms of psychology and Ponzi schemes. That is the foundation that will allow you to design and execute a trade. It is paramount to remember that a high level of luck will be involved. There is no way to anticipate all the things that can impact trading in a stock such as Tilray. You can find ways to increase your odds of success by focusing on technical setups and news flow, but if you are wrong then admit it quickly and move on.
One thing that wipes out more traders than anything else is averaging into a declining stock too big and too fast. The worst situations for that mistake are super-momentum stocks that have topped out and are reversing. Continually trying to catch a turning point is a very easy mistake to make and you can compound the problem exponentially if you don't use hard stops.
When a hot sector trade looks finished I simply will take it off my screen and not pay attention to it. I have not looked at the crypto/blockchain stocks since they topped out late last year.
Super-momentum trading not only can be very lucrative if you approach it in the right way, but also can be great entertainment. Few things are exhilarating as catching a crazy move, but if you always must stay aware of the risk involved.