How do you identify when a stock has started back up after a fall?
When a stock is falling, the first thing we look for are support levels-is there an up trendline to bounce off of, is it using its short term moving averages as support, are there other consolidation levels that may act as support? In a downtrending market as we have had the past few months, we often see these levels that are solid support in the bull runs fail to hold. Stocks will then find bottom at some point, usually at a previous consolidation level and start to move sideways, building a base for a move back up once all of the sellers are gone and demand starts to drive the price back up.
The key question is then, when to make the buy? Some advocate waiting for a breakout of the overall basing pattern, usually a cup with handle, saucer, or similar style base. It is true that when a stock successfully completes such a base and breaks out on volume at least one and one-half times average, the chances of the stock continuing a strong run are greater.
Still, within those bases, which can last several months, we feel there are several opportunities to make profits on a stock before it every breaks out of the larger base. We call these ‘patterns within patterns,’ and can take the form of ascending wedges, flat consolidations, pennants, and even smaller cup with handle patterns. We are always looking for these bullish patterns to develop as they are often associated with a stock building the right side of its base, i.e., after it has hit bottom and starts to move back up toward its pre-correction peak. We can play these patterns short term, or if the stock continues, they may turn into long-term plays as the stock moves up and breaks out. We can then add positions on the breakout of the overall pattern as well.
As noted, we will often play these ‘patterns within patterns’ short term, not really looking for a long term buy, but if it works out, we have a great stock at a great price. Thus, any short term play where we purchased the stock or longer term options can become a longer term hold if the stock continues to improve. What guides us as to when we look for specific long term purchases is the market. When we see the market starting back up on strong volume with advancing issues beating declining issues 3 to 1 and a solid confirmation day (1% gain on higher volume on either the Nasdaq, Dow or S& P 500) 4 to 7 days after the start of a rally, we look at all the stocks we want to buy that have been forming good bases. When they start breaking out in such a market, we are looking to buy long term positions.
Why? Because those bases have a history of giving the best gains in the shortest time period. We want to buy a stock when it is ready to go up, and go up big. We can buy a stock that we feel is a ‘value’ regardless of the pattern and sit tight, and it may or may not go back up. With some big names (e.g., Cisco), we have bought whenever the stock gets in the low 50’s, and we have never been disappointed. But we would rather put our funds to work on generating returns instead of parking them in a stock that we hope will go up. Thus we look for stocks that are showing us good patterns within patterns or are ready to break out of a larger pattern. We can then generate the best return in the shortest amount of time, and then look for more. We may never sell the stock, but at least we bought it at a good time and have a low cost basis after the move up. Then when it or the market corrects back as we have seen, if it is a stock we do not want to sell, we can write covered calls on it to generate cash as it falls. That gives us a return on the stock even as it falls back down. Then when it runs back up, we sit and let it rise, using the money we received from writing calls on it to buy more stock, either that company or another.
Right now we are focused more on short term plays. The market is up an down, still working through its base. We look for stocks that are setting up to move higher and stocks that look to head lower. We play these to generate more capital for the time when the market turns back up and the leading stocks start to break out. Then we focus on the leaders and put all of our money to work to take advantage of that bonanza as the leaders break out and make strong moves.
