Understanding The Physics of "Momentum" Stocks

Today, we continue our throwback to the period of “stonks” in 2021 with a follow-up report on WHY “momentum” stocks work. Enjoy…

In yesterday’s HX Daily, we explained how to approach trading “stonks”…

These high-volatility stocks are most likely to benefit from the current bubble-like environment. As I mentioned, these kinds of assets offer massive money-making opportunities... But you must have a great plan and stick to it to trade them successfully.

However, I didn't address one key issue: Why do "stonks" work?

Remember, while the term "stonks" is a relatively recent invention, the idea of stock market bubbles and volatile, momentum-oriented assets isn't new. We've seen these kinds of stocks in market bubbles throughout history.

Today, almost all investors are inclined to justify stock moves with the news.

It's human nature to see movement in a stock price – either up or down – and then look for new "information" that may have evoked the enthusiasm of the buyers or sellers and moved the stock price.

This is usually the case with stock price movements. If a biotech company announces a successful drug trial, buyers of the stock become enthusiastic and bid it up. Investors dump shares in droves if a company misses earnings estimates or announces accounting issues.

But with "momentum" stocks, the news doesn’t always drive their price movements...

Of course, many momentum stocks need to have a positive news set up to work. You seldom see significant, positive price movements in companies that disappoint analysts or report poor results.

However, it can happen. Look at what happened to the stock of bankrupt rental-car company Hertz (HTZGQ) last year during the pandemic. (Editor’s Note - Hertz eventually relisted and is now Hertz Global Holdings, Inc. (NYSE: HTZ))

Technically, the stock was worthless (or there was a 99% chance it was)... Yet HTZGQ shares went from less than $1 to almost $6 in a few days and continued to trade well above bankruptcy levels for months.

The ultimate momentum stock was video game retailer GameStop Corporation (NASDAQ: GME). While you could make the case that the addition of strategic shareholder Ryan Cohen and some good personnel hires had some effect, no rational observer could argue that the stock's wild moves in 2021 were driven by "news"...

Instead, incremental buying was driven by... buying. Let me break it down...

Imagine a hypothetical example – let's say a stock has 100 "owners."

Something happens to the company – like the addition of strategic investor Ryan Cohen – and attracts enthusiasm from 10 new, excited buyers... And they come in and bid up the stock. This new buying sends the stock up 10%.

That kind of movement in a stock garners much attention. Other investors see it and do a little digging. They see the new high-profile shareholder and may or may not know what that means – or think it's positive – but the stock clearly reacted positively... so it must be good, right?

So, the next group of 10 buyers comes in and bids the stock up further. It goes up another 10%.

The stock is now up 20% in two days. That's a massive move... And it attracts even more attention.

Again, these buyers may or may not have an opinion on the "news," but they see the stock's momentum. The higher prices generate more interest and attract more participants.

Think of these investors as "fair-weather fans." If you see a team on a big winning streak – even if you don't know much about the team and the players – it's tempting to root for it.

Remember, this is all about positive dopamine hits driving our animal brains. Winning and making money is one of the most potent hits out there.

This pattern continues and builds upon itself. The more the stock goes up, the more buyers looking to "play a winner" get involved... And the stock goes even higher.

At some point, though, this activity exhausts itself. It always happens.

There could be a catalyst for the exhaustion. For example, we recently saw media company ViacomCBS (VIAC) announce a big stock offering after one of these massive momentum moves. (Editor’s Note - VIAC eventually relisted and is now Paramount Global (NASDAQ: PARA))

In this case, the company issued so much stock that even though there were incremental buyers based on the momentum, there was way more stock than these buyers wanted to own.

At that point, VIAC shares dropped.

This is the most essential point in understanding a momentum stock. Once we break the cycle of going up every day (or consistently) and going up a lot, the enthusiasm of the buyers wanes.

Also, remember they were only there for one reason: The stock was going up.

Once the stock stops increasing, they no longer have a reason to be there. So what do they do? They pound the "sell" button.

At that point, selling begets selling.

All of these recent buyers quickly move from "greed" to "fear" and "panic" and run for the exits.

This is why we say momentum stocks never correct by consolidating or going sideways... They always go down.

What was the last “momentum” stock you participated in? Did you make or lose money? Let us know in the comment section below.

So, how do you handle these kinds of situations?

Remember one of the rules for trading "stonks" from yesterday... If you quickly make 100% or more in a position, consider selling 50% to 60%. That way, you lock in your original capital and a profit and can let the rest of the position ride.

If you own one of these momentum stocks, sell it all once you see it go down at least 20% or down across any three days.

That likely means the momentum cycle has broken. And while the stock may bounce back, remember there's symmetry to markets. Stocks that quickly go up a lot also promptly go down a lot.

This concept of stock prices driving stock prices isn't widely understood... But understanding it can make you a much better trader in these potentially profitable situations.

Check out Enrique Abeyta’s conversation with Whitney Tilson on the HX Podcast.