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By Costas Bocelli - Creator: Channel Trading Secrets
Momentum stocks always seem to captivate investors.For some, the valuations and volatility are just way too extreme for their investment goals, but for the active trader and the above-average risk taker, playing in the stock and option markets in these high fliers have the potential to return massive gains.
So what exactly are momentum stocks?
We’re not talking about stocks like Wal-Mart (WMT) or Procter & Gamble (PG) that trade with a very tight fundamental correlation to the plain vanilla discounted cash flow models that are found in your typical business school textbooks.
Momentum stocks are indeed an entirely different animal. They tend to toss the fundamentals into the back seat and drive full throttle on the technical price action -- at least in the short-term.
That’s the allure... big moves in short spurts.
And what often really drives the price action in these stocks is earnings announcements.
We’re about half way through second quarter earnings season, and we’ve seen quite a few of them report, producing many of those big moves in the price action.
Just this week, Netflix (NFLX), Panera Bread (PNRA) and VMware (VMW) all reported. And all three of these stocks can be categorized as momentum stocks.
Panera Bread trades with a price to earnings ratio around 30. VMware has a touch more frothy valuation with a 50 price multiple. And Netflix trades at 80 times earnings estimates on a forward looking P/E basis! We won’t even mention what the current P/E is on the online content provider.
The fundamental picture for these stocks can be so convoluted on their forward looking business plans that many of these companies even have two sets of accounting books.
That’s right. They report earnings the old fashion way using generally accepted accounting principles (GAAP), but they also report Non GAAP results based on whatever metrics they feel are relevant to framing the right picture of where the company may be headed in the distant future.
And that’s what tends to be the driving catalyst that determines price action when they report earnings and forward guidance.
You see, trading momentum stocks is like pulling the slot machine handle and hoping to come up with a bunch of cherries.
The moves can cut both ways too. You see big pops like VMW... but you also see big drops like PNRA.
The key to trading the momentum stocks is obviously being on the right side of the move and, depending on your opinion, you’ll quickly find out on which side of the P&L column you’ll wind up.
But where the edge really lies is in getting a feel for how much of a move is likely to occur.
You see, I can’t necessarily help you pick the direction of the stock move, but I can help you with gauging the likely magnitude of the move.
"Why is that important, and how can this help me?"
When you take a trading position, you should have a game plan.
Where do I set my stop-loss? Where would be the optimal point to set a profit target?
If I’m an options trader, what strike do I want to buy? Which ones do I want to sell? Which strategy may work best?
That’s lots of questions I just threw out at you... and now I’m about to give you a down and dirty tip that the professional traders use to easily make an educated determination based on probability theory.
I’ll also share with you a timely example that you can follow along in just a few hours to see how accurate the prediction may be in forecasting the magnitude of a price move.
Here’s how it works
Momentum stocks tend to be actively traded with lots of liquidity, and offer many strike prices and expiration cycles in the stock’s option market.
What we want to do is locate the nearest expiration, which is usually a weekly option that expires on Fridays.
Then we want to price the at-the-money straddle, which is the strike price closest to the stock’s current trading price. Don’t worry -- it’s very easy as long as you can add two numbers together.
A straddle is simply the purchase or sale of the corresponding Call and Put in the same expiration cycle and the same strike price. So we’ll simply add the price of the Call and the Put and then we’ll have the price of the straddle.
The straddle price is essentially acting as the implied breakeven around the strike price, or since we’re using the at-the-money strike, the breakeven around the stock price.
The straddle price is set by all the buyers and sellers that are actively trading the call and put contracts. They attract the retail customers, the fund managers, the smart-money with the top notch research and even the cheaters -- the more the merrier actually.
What this means is that efficient market theory is pricing out the probability of the expected move for you, and thus giving you a good idea on how big of a move may be coming, just not the direction unfortunately.
But again, if we could trade with tomorrow’s newspaper we would be richer than Warren Buffett. However, getting a feel for the magnitude is what can help us mere mortals with our trading decisions like setting stops, picking the best option or even applying the appropriate strategy.
The one caveat is that this trading tip is not 100% foolproof, but from my experience, the magnitude of the expected move usually pans out about two-thirds of the time, which is a nice edge in my book.
Here’s a timely example...
Amazon.com (AMZN) reports earnings after the closing bell today. The stock will be trading very actively in the aftermarket and into Friday, and it happens to have a Friday, July 26 weekly option, which is ideal for our exercise since it expires within one trading day after the earnings release, essentially making the straddle price a pure play on the price action move off earnings.
With AMZN trading at 299.00, I looked at the July 26 weekly 300 strike Call and 300 Strike Put, which is the at-the-money strike price. The Calls were 8.35 and the Puts were 9.45 for a total of 17.80 for the straddle.
That’s the “money zone” -- meaning, the upper and lower hot spot on the anticipated move after earnings.
If we see a positive reaction, we should see AMZN trade about 18 points higher to around 318 per share. And if they disappoint and the stock sells off, then AMZN should drop 18 points to around 282 per share.
It's at those levels where the winners and losers will begin to fight based on the straddle price, and it usually takes a big force to escape those pressure points (the other one-third of the time when we happen to miss our forecast).
The bottom line is that the options market is loaded with free information, and even if you haven’t traded an option in your life and rather prefer trading the underlying instead, simply adding two numbers together and using this quick and easy technique can give you a real time perspective on how big of a move is likely in store heading into a news driven event like earnings.
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Costas began his trading career in 1998, at Gateway Partners, an Equity Options Trading Specialist Unit on the Philadelphia Stock Exchange (PHLX). During his successful tenure, and though unprecedentedly volatile trading levels, Costas boldly and adroitly navigated the global "financial meltdown" that saw the downfall of the hedge fund and of Long Term Capital, and the Russian Currency Crisis. Having achieved the coveted Senior Equity Options Market Maker position for his firm, Costas eventually left to join a proprietary trading desk, where he successfully makes markets for large customer and institutional orders. In addition to his more than 7 years of experience as an options market maker, Costas has also trained and educated many junior traders on option theory, risk analysis, and strategy. His passion is helping self-directed investors achieve all of their financial goals through a clear, practical understanding of the power of options and of the many benefits of trading in a proven systematic way. |
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