Saturday Review: Shorting Momentum Stocks

This post from August 2007 offers some timely advice on shorting momentum stocks:


Those of you familiar with my trading style know I rarely short high flying stocks. While it seems logical to go against a stock that is overextended, this type of trade generally takes on too much risk. Stocks tend to trend longer than they "should" due to market psychology and short squeezes.

However, there is one contrarian setup that I do use on momentum stocks. A stock that reaches it's high, without RSI and OBV confirming the move, gets my attention as a short play.

Take a look at the GRMN chart. During the last high, OBV and RSI levels were higher than they are now. This "negative divergence" is a sign that the stock is not ready to rocket to new highs.

A negative divergence is not enough to jump in. We also need to see a failure at the old high level. We've got that here with GRMN. The stock stopped right at $105 and has pulled back.

The last piece of the puzzle is volume. Volume patterns in this stock are not bullish. We've seen more volume on the downside than upside. This was enough to get me in as a short today.

I went short 100 shares of GRMN at $102.65.

Note that I am not making a big bet here. I took a small position and my stop is above the old high at $105.50. I am risking less than $300. It's never a good idea to make big bets against the trend.

Shorting Momentum Stocks: the GRMN Trade

Those of you familiar with my trading style know I rarely short high flying stocks. While it seems logical to go against a stock that is overextended, this type of trade generally takes on too much risk. Stocks tend to trend longer than they "should" due to market psychology and short squeezes.

However, there is one contrarian setup that I do use on momentum stocks. A stock that reaches it's high, without RSI and OBV confirming the move, gets my attention as a short play.

Take a look at the GRMN chart. During the last high, OBV and RSI levels were higher than they are now. This "negative divergence" is a sign that the stock is not ready to rocket to new highs.

A negative divergence is not enough to jump in. We also need to see a failure at the old high level. We've got that here with GRMN. The stock stopped right at $105 and has pulled back.

The last piece of the puzzle is volume. Volume patterns in this stock are not bullish. We've seen more volume on the downside than upside. This was enough to get me in as a short today.

I went short 100 shares of GRMN at $102.65.

Note that I am not making a big bet here. I took a small position and my stop is above the old high at $105.50. I am risking less than $300. It's never a good idea to make big bets against the trend.

Google Forming a Negative Divergence

While GOOGLE (GOOG) made my long position trading watchlist (entry at 50 day moving average), I could not help but notice the startling RSI, OBV and stochastic divergences that have formed at the current new highs.

For those who don't know, a negative divergence forms when price increases while the indicators decrease. As you can see from the chart below, that is precisely what is happening to Google.

While it is tempting to short a stock at the moment a divergence is spotted, only aggressive traders willing to take on high risk or use a very tight stop should go short now. The more prudent way to play this divergence is to wait for the stock to break below the old high before going short. Here we would short on a break below $535, with a stop above the old high and a target near the 50 day moving average, approximately $520.

While the stock is on my very short term "short" watchlist, it is also on my longer term postion trading "long" watchlist. I would enter long on a pullback to the 50 day moving average. In an ideal world, I'd be able to short down to the moving average, then reverse and go long.