The Perils of Chasing Hot Stocks
People love hot stocks, those names that are making big gains on strong volume and attracting a crowd of speculators which continue to drive it higher. Invariably what happens? They end up losign money in monster stock? Why because they made an emotional decision, listened to the story, and ignored the chart. Chasing stocks means that you buy in to these stocks too late, paying a price that has more downside risk than upside potential at the time of your purchase.
Ask Yourself: Am I late to the party?
Even if you are not an expert at reading stock charts, taking the time to check the chart before you buy a stock. When looking at the chart, you should evaluate how far the stock has moved from its most recent area of support. The farther a stock moves from its floor, the closer it gets to its ceiling- or a temporary pullback that will stop you out for a loss.
How Far Is The Stock From Support?
To see where the relevant price floor is, look at the chart and determine the last time the stock traded sideways before it started to show strength. Draw a line across the bottom of that sideways trading range.
Are You Chasing?
Now, look at where the stock is now. How long has it been going up? How far up has it moved relative to the normal trading volatility of the stock?
All Boils Down To Risk vs Reward:
I don’t like to chase stocks that have moved far up from their price floor because the downside risk is too much for the upside potential. If a stock is destined to move from $10 to $15 but there is a risk it could go down to $9, you don’t want to buy it at $14. It makes sense to pay $10.50 because your downside is $1.50 while the upside is $4.50.
Keeping this concept in mind, it may be ok to pay a higher price for a stock if it has just recently moved up from a period of sideways price movement. That sideways price movement is a foundation for a trend, it gives you a well-defined floor for risk management.
One Problem With Buying Breakouts:
It is ok to buy breakouts as long as they are not too extended from support. Remember most breakouts fail or at least negate the breakout and then take off. This could stop you out for a loss whereas the advanced entry point (closer to support) buyer would still have a lofty cushion. When buying stocks, buy them when they are just starting to behave abnormally, getting in as close to their price floor as possible. The higher the stock goes, the riskier it gets.
Based on: SCweekly commentary