So you find a hot stock. What’s next? Make informed decisions by using a well-defined process to trade with less stress and less heat. These are the seven steps I use to evaluate each and every potential candidate.

Step 1: Sentiment Analysis

Start by looking at recent news headlines. This information helps us determine which phase of the Investor Sentiment Cycle the stock is in.

Check (i) Google Finance for market cap, recent news stories and discussion, (ii) Yahoo Finance for the News & Info and Analyst Coverage sections, and (iii) CNBC Video to see who said what on air or at the site.

Let’s use Amazon Inc. as an example. The stock hit a new all-time high on November 30, 2009, and of course, there were traders interested in the “breakout.” CNBC was all excited, doing segments in connection with Cyber Monday.

Ask questions. If the stock has been rising into expected good news, will investors take profits on the announcement? If it has been falling into expected bad news, will buyers show up on the announcement?

Is this a classic behavioral finance trap? Is it smart to follow the dumb money?

Step 2: Check the Moving Averages

The 50/200 “cross” is a very popular scan criteria used by legions of retail traders. Their thesis goes something like this: the up or “golden” cross (50-day MA moves above 200-day MA) is supposed to be bullish while the down or “death” cross (50-day MA moves below 200-day MA) portends to weakness.

Daily Chart, with 50- and 200-day Moving Averages

The problem with moving averages is they tend to whipsaw when there is no trend; therefore, just like most other scan criteria used by the masses, moving averages “work” only when a massive trend takes place … afterward.

Why monitor scan criteria that offers little predictive value? Because, just like my Keynesian “beauty contest” stock scan, the 50/200 cross generates a list of ideas, stocks that come to the attention of others who use this popular scan criteria and trade it blindly.

Step 3: Check Volatility

A stock that is thrashing wildly increases risk for traders since a stop loss must be wide enough to accommodate the price action. Standard deviation (”historical”, or “realized” volatility) and our range indicator provides us with a measurement. In general, a low reading means the stock price is pretty tame (even though it may be in an up or downtrend) while a high reading means the stock is all over the place and demands extraordinary risk management.

Daily Chart, with Volatility Indicators

Research indicates that periods of low volatility is interrupted by periods of high volatility that tends to cluster when market participants are in a panic to sell. Panic buying is more rare, but is generally indicative of an upside blowoff.

Step 4: Check Relative Momentum

Relative momentum is the measurement of the price movement of A against B. First, we determine the appropriate benchmark index. We check to see if the stock in question is a constituent of any of the major stock indexes such as the S&P 500 Index, the NASDAQ 100 Index or the Russell 2000 Index.

Measure a sector index against a broad index using SmarterStops.RMI. This type of analysis is often called “relative strength” (NOT the same as Wilder’s RSI or the IBD ranking) or “ratio charts”, and since there is so much confusion, I call it relative momentum. In general, use the S&P 500 as the benchmark index for all ETFs since sector rotation is based on outperformance against a broad index, as are other asset classes and countries.

Daily Chart, with Relative Momentum Indicators

The RMI Histogram compares price action of a stock (or sector) against an appropriate benchmark index while the RMI PaintBar colors price bars according to the status of the histogram values. This provides me with (i) a detailed, bar-by-bar account of a stock’s performance against the benchmark and (ii) helps identify potential change of trends in the big picture when price bars are painted yellow.

The position of the green and red histogram bars relative to the grey threshold line is very important. A number of combinations and permutations can occur. Price bars are colored based on information contained in the histogram according to these rules:

1. Green = RELATIVE OUTPERFORMANCE = Histogram > 0 AND Histogram > Threshold Line
2. Red = RELATIVE UNDERPERFORMANCE = Histogram < 0 AND Histogram < Threshold Line
3. Yellow = POTENTIAL CHANGE OF TREND = all other combinations

Having a tool that objectively measures relative momentum is very important because knowing where we stand in the Justin Mamis Investor Sentiment Cycle is often the only way to protect yourself. Investors tend to be extremely bullish at the top and very bearish at the bottom. Relative momentum tools can help traders avoid performance chasing (buying after a long uptrend) and countertrend trading (buying all the way down).

Step 5: Is There a Technical Trade Setup?

Is there a valid reason for entering this trade? Is there a technical trade setup on this chart? Think, strategize and Trade Like a Commando by identifying trade setups by process of elimination.

Daily Chart, with Smarter.Swings

Look at the structure of the swings connected by the swing lines. Is there a pattern of higher swing highs and higher swing lows? That is an uptrend. Is there a pattern of lower swing highs and lower swing lows? That is a downtrend. Is there no pattern? It’s probably choppy.

Step 6: Position Size and Execution

Are all your eggs in one basket? Be sure to calculate appropriate position size to limit risk to capital. Traders should consider using call or put spreads to further reduce risk. Bull call spreads and bear put spreads can be selected using the dots generated by Smarter.Stops.

Step 7: Where is the Stop Loss?

If you are already long or short, then things are easy: follow the Smarter.Stops dots. They are engineered to reflect actual volatility and range, providing with a real edge over other so-called volatility-based indicators or bands.

Daily Chart, with Smarter.Stops

Use Smarter.Stops according to the following two rules:

• BUY RULE: A *close* above a blue dot is buy signal.
• SELL RULE: A *close* below a pink dot is a sell signal.

Stops must accurately reflect volatility and range. Stops must never, ever be based on what the trader can afford to lose. They must be placed where they ought to be and we reduce our trading size as required to manage risk to capital. This is our definitive edge.

A Word About Stocks

Stocks that I review usually appear on The Hot 100 List or the Winners and Losers tab of The Daily Workbook.

Stocks are ranked by price momentum. In a rising market, stocks at the top of the list are the ones that everyone wants to own. They are the bubble stocks, the tulips. Be careful buying those. In a falling market, stocks that are at the bottom of the list are the ones everyone is dumping. They are the dogs being sold at any price. Be careful shorting those.

What you should do with these ideas are up to you. I suggest investors should make speculative trades in individual stocks only with mad money after fully funding retirement accounts according to a balanced portfolio strategy.