There seems to be a lot of carrying on about momentum stocks imploding after huge runs, as if it’s something terrible and scary. 

Stocks like Green Mountain Coffee Roasters (GMCR) and Netflix (NFLX) have plummeted over the last six months or so.

‘Oh my god, a momentum stock has fallen sharply’!!!!

I know it’s not pleasant being caught up in crashes.

But if you don’t think momentum stocks should or will fall, then you have no business trading them.

It’s called risk and volatility.

We’re riding the gales of creative destruction.

Momentum stocks are risky. That’s why they outperform the market over time. It’s why momentum traders earning a premium.

So what can you do about it?

Firstly, accept the risk.

Momentum stocks sometimes implode. Of course they do. That’s the nature of the beast. They are growing rapidly and have high earnings estimates. When that growth slows the market is disappointed. You’re also playing the game with other trigger-happy traders who flee at the first sign of trouble.

If you don’t like risk and volatility, buy bonds, or invest in cash, or buy an index fund. All are very valid options.

Secondly, get out as soon as it starts falling

There is no excuse to being caught in a steep sell off. As soon as the stock starts going down, as defined by the Only Profit-taking Rule You Need, you’re out of there.

I spoke about this recently with regards to GMCR.

That said, there is no way to avoid being caught up in a profit warning and big gap down in a strongly up trending stock.

You just have to accept that it’s something that happens to momentum stocks you invest in.

What else can you do?

There are some things that may minimise the chances of getting caught in a profit warning, and help minimise the damage to your portfolio.

The aim, at least, is to have any falls come from profit on existing gains, rather than from your capital. (I’ve already had large profits in most profit warnings on stocks I own I’ve been caught up in.

1.    Try and get on board early

Try and buy at the start of a momentum stock’s second big leg. It’s usually when the 50-week moving average starts to turn up (usually after the stock has already gained 50 to 100 per cent).

2.    Consider adding some quality screening factors

Here is a summary of five factors to look for to judge the health of a company (this article refers to beaten down growth stocks, but it applies equally to strong stocks.

3.    Sell more quickly

I advocate riding a stock till the end. But you might choose to take profits more quickly to avoid exposure. That’s an option. But it still doesn’t remove risk entirely. Short-term traders also get caught holding stocks that issue profit warnings and gap down.

4.    Do deeper qualitative research

Get to know a company better: monitor the market it operates in closely and be ready to detect any change in conditions and sales. This, obviously, is more suited to investors with more time and resources.

5.    Diversify risk

Don’t risk more than 2 per cent of capital in stock. Don’t let one stock become more than 25 per cent of your portfolio. If a stock crashes 20 per cent in a profit warning and it makes up 25 per cent of your portfolio, the damage done to the portfolio is only 5 per cent.

6.    Don’t pyramid up

Don’t keep adding to your position as it goes up.

7.    Don’t use margin

I’ve found that when I go on margin, because I’ve run out of cash to buy, it’s time for a steep correction in the market or stock.