The Odds on Momentum Trading
By Jeff Clark
February 28, 2007
There's a reason the game is called craps.
"The idea is to get behind a hot shooter," said a buddy of mine on a recent trip to Las Vegas.
I don't gamble. There's no point to putting up money when the odds are always on the house. But my friend insisted he had a winning system, and I skeptically tagged along to see it in action.
Early on in the evening, my friend was up a bit more than $10,000. He was at a hot table with a hot shooter, and he was doing quite well.
I glanced curiously at the table. The shooter had been throwing the dice for so long that just about every number was covered. My friend was betting on them all – and taking the odds on each bet.
"How much money you got out there?" I asked.
He shrugged his shoulders and said, "Don't know. I'll count it on the next win."
The shooter then hurled the dice across the felt top of the craps table. The dice bounced and ricocheted off the bumpers and finally came to rest.
"SEVEN!" shouted the man in the white shirt and bow tie as he reached over with a rake and cleared the felt of all the ill-fated bets.
My friend had more than $12,000 on the table. So, in one roll of the dice, he lost all of his profits for the evening – and then some.
Quite a system, I'd say.
The same thing goes for momentum investing.
I turned cautious on the stock market a couple months ago. I was never outright bearish – just very concerned about the prospects of a correction. And I took a lot of heat for that position.
Rightly so, I suppose, since the market kept moving higher – despite all the technical sell signals, despite the underperformance of the semiconductor index, and despite the poor action in Merrill Lynch, Wall Street's version of the canary in the coal mine.
Momentum investors stayed behind the hot shooting market, and they made a lot of money with that system... until yesterday, when the man in the white shirt and bow tie raked away all of the market's gains for the year – and then some.
Of course we all know the old adage to "let your profits run." I suppose that applies more to investors with long-term time frames. Because it doesn't work for traders.
It's important for traders to take profits off the table. Regardless of how well the position is acting, paring back and putting profits in your pocket is never a bad idea – especially when dealing with short-term put and call options.
We do this consistently in The S&A Short Report. Last Friday, we sold half our position in OmniVision call options for a gain of 100%. The stock is still dirt cheap, and the technical pattern is bullish. But with earnings coming out later this week, it made sense to take a little off the table.
We also closed out our call position in Encore Wire on Monday – for a 212% profit. Here again, the stock is dirt cheap, and the technical pattern is still positive. But the stock was up on takeover rumors, and we took our profits before those rumors faded into the background.
Momentum investors are inclined to let the profits ride. And we saw how that strategy can backfire when the market behaves as it did yesterday.
A far better idea is to take your profits at various price targets along the way. Yes, you might miss out on further gains, but you'll never have to watch as the man in the white shirt and bow tie rakes all of your money to the other side of the table.
I don't gamble because I don't see the point of putting up money when the odds are always against you.
I don't trade based on momentum for largely the same reason.
Best regards and good trading,
Jeff Clark
