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Investing always carries some risks, but momentum investing in cannabis stocks has some unique risks you should be aware of before trying it. This article explains some of the risks and provides guidance on how to avoid them. (Most of the time, just knowing of the potential threat is all you need to avoid it.)

Before adopting any investment strategy with real money, try it with fake money. Numerous financial websites feature sample investment portfolios or simulators, such as Investopedia’s Stock Market Game and the MarketWatch Virtual Stock Exchange. Most of these simulators are set up as games in which you compete against other investors.

Watch out for the short squeeze

A short squeeze is a spike in a stock’s price that forces a large number of short sellers to close their positions, which pushes the price higher. Short selling is a strategy for profiting from a stock when its price drops. A short seller borrows shares from another investor, immediately sells them, then waits for the stock price to drop. When it goes as low as the short seller thinks it will go, he buys shares at the lower price, returns them to the lender of the shares, and pockets the difference.

If a short seller buys stock expecting the price to drop and, instead, the price rises, the more it rises, the more money the short seller stands to lose when he ultimately decides (or is forced) to close his position. At any time, the lender of the shares can demand their return. When or even before that happens, the short seller may close his position (buy shares and return them to the lender to cut his losses), further driving up the stock’s price and trading volume.

As a momentum investor looking at a simple moving average chart and the trading volume, you may believe that this surge in price reflects the popularity of the stock when the increase is really due mostly to short sellers panicking.

Stock exchanges release short interest data every month (or more often), and you can usually obtain this data by visiting the stock exchange’s website. For example, to obtain short interest data from Nasdaq, you can take the following steps:

  1. Open your web browser and go to www.nasdaq.com.
  2. Type the stock’s symbol or the company name in the Find a Symbol box, then click the stock in the drop-down list that appears.
  3. In the navigation bar on the left, click Short Interest. A list appears, showing the number of shares being shorted, average daily share volume, and days to cover.
Short interest data. Short interest data

The higher the number of days to cover, the greater the short interest, and the stronger the belief among short sellers that the stock price will drop. If you’re thinking of buying on the upward momentum, you may want to reconsider. However, some investors, known as contrarians, will buy when short interest is high, thinking that if the share price continues to rise, short sellers will be forced to buy even more, which will drive the price higher. In other words, their strategy is to make money specifically on the spike in price caused by the short squeeze.

Steer clear of pump-and-dump scams

Many cannabis stocks are penny stocks, meaning they’re cheap, which makes them easier to use in pump-and-dump scams; con artists buy lots of shares, then they get lots of suckers to buy them, which drives up the price. As soon as the price is high enough for their greedy, cheating minds, they dump their shares, taking their profit while the other investors lose a ton of money.

Avoid cannabis stock and industry bubbles

Investors often pour money into “sexy” companies, including just about all companies in the cannabis sector. All this money drives stock valuations sky high, which creates a bubble, and all bubbles eventually burst. During the dot-com boom of the 1990s, speculators drove the value of the Nasdaq composite index higher than 100 times its forward earnings, with some companies valued at 300 times their forward earnings. When the dot-com bubble burst over the course of March of 2000 to February of 2003, the Nasdaq composite index lost 70 percent of its value.

The moral of this story is to check a company’s fundamentals before investing in it, even if you’re doing momentum investing. Pulling up a company’s price-to-earnings (P/E) ratio takes only a few seconds and serves as a valuable “sanity check.” Sure, already inflated stock prices can continue to rise, but they almost always drop, and when they do, you can lose a lot of money trying to buy high and sell higher.

Know when momentum investing works and when it doesn’t

Momentum investing typically delivers better results during periods when markets are relatively stable. During periods of significant volatility, other investment strategies may be more effective, such as diversification (which is always a good idea), investing in value stocks, and holding onto some cash.

Volatility is fluctuation in the price or value of individual stocks, sectors, or the stock market overall. You can gauge the volatility of a stock by looking at its standard deviation—the average amount a stock’s price has differed from the mean (average) over a period of time.

Instead of getting into the math, just pull up a chart of the stock’s price over the desired period of time that shows Bollinger Bands, which consist of three lines: a line showing the simple moving average (SMA), a line showing the standard deviation above the SMA, and a line showing the standard deviation below the SMA. The greater the distances between standard deviation lines and the SMA line (that is, the wider the band), the greater the volatility.

Use Bollinger Bands to gauge volatility. Use Bollinger Bands to gauge volatility.

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