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Trade 'Hot Money' Stocks Carefully; They Can Burn

It's a good sign for a stock to have strong backing from hedge funds and other institutional investors. But when can institutional buying become a curse

Sometimes a hyperactive fund or two will look to make a fast buck in small-cap stocks that boast strong fundamentals and an appealing backstory.

This helps to explain why such "hot money" stocks will sometimes rise like a Phoenix only to crash and burn just months or even weeks after the breakout.

Such stocks, in other words, may only produce one good base. After a nice breakout and rally, the run is over.

To guard against such a fate, keep emotions in check and watch fast-moving small-caps (in general, those with a market cap of less than $1 billion) very closely. Follow sell rules. Also, avoid chasing the stock or pyramiding liberally.

Consider the wild adventures of InvenSense (INVN). The maker of motion-processing chips went public in November 2011 at 7.50. Its market capitalization at its IPO was less than $1 billion. Sales growth was strong; yet sales on a quarterly basis were limited to the tens of millions of dollars.

InvenSense quickly formed its first base, a cup-without handle with an 11.95 buy point 1 (weekly chart is shown).

InvenSense had an alluring tale to tell. The Sunnyvale, Calif.-based chip designer was rumored to supply motion sensors to Apple (AAPL) for its hot-selling iPhones and for Microsoft's (MSFT) X-box game console.

Profit growth was rapid, rising 250%, 117% and 133% in the three quarters through March 2012. Sales growth was similarly strong, rising 83%, 52% and 39% over that period. InvenSense made its way onto the IBD 50 and in Leaderboard.

On Jan. 9, 2012, InvenSense broke out above the 11.95 buy point. 2 Volume was 714,000 shares, third most since the base started forming. Turnover picked up to just over 1 million shares the following day.

The stock raced up 61% over the next five weeks, hitting a high of 19.34 on Valentine's Day. 3 That's a red-hot move. Along the way, however, volatility picked up in contrast to the stock's orderly, tight base.

InvenSense pulled back sharply in strong volume to the 10-week line before lurching back up to a peak of 22.35 on March 26. 4 The four-week base it formed was too narrow and thus flawed.

From there, the stock plunged as fast as it soared, dropping 15% in one week and 12% the next. In just seven weeks since peaking, InvenSense made a round trip, falling below its original entry. 5 A good time to have sold would have been on April 4, when the stock crashed through its 10-week line in huge volume. Today, InvenSense remains sharply below its proper entry point.