Momentum Trading: Dumpers, Gainers, News Stories and Publication Stocks

Growing up, my daughter loved the The Wizard of Oz. She watched it over and over again. And every time, she shrieked with delight when she discovered that the Wizard was just a small nervous man behind the curtain.

I think of the man behind the curtain every time I look at an intraday chart or a time sales chart scrolling tick by tick across the screen. It doesn't look mechanical or impersonal to me, as it does to most traders. I realize that there are thousands of anxious people behind each and every trade the market makes.

The key to high-percentage trading is learning how the people behind these trades, under certain circumstances, react predictably to certain types of events, numbers or patterns. Now I'm not saying a background in psychology will increase your winning percentages substantially, but if you understand this approach you can predict the patterns a good percentage of the time.

Investors react predictably to news and fundamentals. Technical analysts react predictably to patterns, resistance levels and a wide variety of indicators. Daytraders react to momentum and volatility. Two things drive them all -- fear and greed. Maybe Freud would have been a good daytrader.

Anyway, when I trade a stock, I not only play the momentum, but also the traders behind that momentum. With this approach, I can reasonably predict how four specific patterns react most of the time.

In columns over the next few weeks, I will start an in-depth discussion on how to find, recognize and play each of these four patterns. I'll begin today with a brief look at each one:

Dumpers

Dumpers are stocks that dump 20% or more on mediocre bad news, such as missing earnings by 1 cent. The market always overreacts to bad news, and I play the bounce or corrections at the bottom. I play only mediocre bad news and not extremely bad news dumpers, such as Securities and Exchange Commission investigations or bankruptcies, which could cause a stock to de-list.

An example of a dumper is Starbase (SBAS Quote), a leading provider of e-business digital asset management solutions. It announced earnings on Feb. 10 and although revenues were up, the street apparently was not satisfied. The stock gapped down the next day, creating an excellent opportunity to play the first bounce.

Gainers

Gainers are stocks that are up 20% or more on good news. Remember, the street overreacts not only to bad news but also to good news. In the case of good news, everyone wants on board, and I take advantage of this overreaction and ride the momentum.

A classic example would be a company that releases a favorable earnings report, or is upgraded by an analyst. If the story is strong and is reported after the bell, the stock will normally gap up, sell off a bit at the open, then take off. When this pattern is repeating, I buy at the first dip and ride the momentum up. If the story is weak, and the overall market indicators support it, I short at the first high and wait for the street to digest and understand the news. Once it does, the stock normally drops a fair amount. Again, we take advantage of the street's overreaction to the weak good news.

Superconductor Technologies (SCON Quote), which makes products to improve cellular telecommunications quality, more than doubled from the close on Feb. 15 when it announced it had plans to sell 27 SuperFilter Systems to an unnamed cellular service provider. The news was strong, and was a classic example of a stock to play the first dip and ride the midmorning momentum.

News Stories

I scan the news all day long and wait for a great news story to hit. I'm forever looking for the company that reports it found the cure for cancer or, more importantly, for traders interpreting the news as if the company is reporting it has found the cure for cancer. I will play only fresh news stories, and only if I think the news is strong. Sometimes news that appears fantastic will hardly budge a stock and news that appears weak creates incredible momentum. Reading and interpreting how the news will affect a stock is an art all in itself. I have spent years tracking how different types of news affect the movement of stocks.

Advanced Electronic Support Products (AESP Quote) was a classic news story on Feb. 16. It ran from 2 5/8 to 7 15/16 on the news that it had been added to Cabling Business Magazine's "Cablenomics" portfolio of networking companies.

Publication Stocks

These are stories in magazines like BusinessWeek and Newsweek. I play the oscillations as the story is read over and over again during the course of the week. I get the jump on the majority of investors by reading the stories online before the paper copy is read by millions of hungry investors. This pattern does not always repeat, but when it does, it's worth its weight in gold.

StarMedia Network (STRM Quote) was featured in BusinessWeek on Feb. 11 (Feb. 10 for the online version), creating this very predictable pattern.

I started my daytrading career with a $6,000 portfolio, so I had little room for error or loss. I developed my style of trading with one thing in mind: capital preservation. The key to capital preservation is identifying and playing only the high-percentage plays. The key to identifying them is to know what the expected reactions of certain patterns will be, and to play only those patterns.

Now, I'm no stock market wizard, but I've been over and under the rainbow enough times to share how I finally found my yellow brick road. Next week, I'll start taking you down it. I'll start with dumpers. I'll discuss how I identify and play them, as well as how I identify intraday bottoms and tops.