1. When to Buy
Through the course of Part III, How to Find and Evaluate Stocks, we discuss about how to find the stocks best suited for you.
So, you know what stocks you’re going to be looking for!
The next most pertinent question is to ask when it is the right time to buy these stocks.
Market researchers believe that finding the perfect stock to invest in should be followed by reviewing of two important indicators:
- Market Conditions
- Stock Chart Review
Understanding the market psychology is always considered to be of utmost importance by seasoned traders.
And why is this?
Traders believe market is driven by two human forces – fear and greed.
Market Psychology is a phenomenon where the fear and greed which emerges out of a collective participation of traders affects the market trends.
For example, when a large number of traders are fearful about a stock falling, mostly the stock falls!
Making the fear of the trader come true.
The same case can be viewed with respect to a trader’s greed as well.
So, dip your feet into the overall feel of the market condition, before knowing when to buy.
The popularly agreed theory is to buy stocks when the market is in an uptrend.
So, wade in only when the market conditions seem favorable!
Stock Chart Review
The most widely accepted logic is to understand Chart Analysis, you must first analyze the prevalent market conditions (or market psychology at play).
Chart Analysis is based on two market elements – Support and Resistance.
Support is a price level where “greedy” buyers enter the market to prevent prices from declining further, while Resistance is a price level where “fearful” sellers suddenly come into the market and prevent prices from advancing further.
The importance of Charts and its functionalities have been discussed at length in How to Read Charts.
So, by now we’re aware of how charts help you locate the best stocks to invest in and to track the market trends.
Nevertheless, many investors still underestimate the value of stock charts.
With the help of a little training and practice, one can learn the use charts to make precise trades in the stock market— at the optimal price and time.
When things wouldn’t seem to go your way in the market, these charts will help you know when to exit your position.
Most traders believe that it is important to note that the stock is breaking out of a common chart pattern as this could indicate a warning before big gains.
Research also indicates that same chart patterns repeat year after year.
Keeping these factors in mind, we realize how we cannot make do without charts in trading! And we never should!
2. Overview of Bases
To begin with, what are bases?
What are the advantages associated with Bases?
Bases help you figure out when to invest in a stock. One of the vital ways in which Bases help you do so is through well-elucidated chart patterns.
Let’s look at the 4 major chart patterns associated with Bases:
(1) Left Side of Base: This particular pattern is associated with Sell-off bases.
The Sell-Off Bases start after a stock has begun moving up for a while (typically a few weeks or months), then begins to decline.
This indicates that institutional investors or fund managers could be cashing in the profits they made in the prior market run-up.
It occurs when the market starts to slip into a downtrend and the phenomenon gets its name from the left-sided pattern created out of the sell-off.
(2) Bottom of Base: Bottom of Base is a pattern which forms when stocks being sold in the market subside.
This usually occurs because large number of investors stops selling and begin buying shares again.
Nevertheless, this pattern does not suggest whether a stock has regained its lost strength or might plummet lower in the future.
Therefore, most investors suggest buying stocks based on bottom of the base as an unnecessary risk.
A chart pattern is being formed and it does not provide us a clear-cut idea about the stock trend.
Instead, investors believe a smarter move would be to wait for the base to be formed and break out on heavy volume.
Why would this help? Because it greatly reduces your risk and leaves enough space for potential market profits.
(3) Right Side of Base: A pattern forming on the right side of the base indicates institutional buying returns.
This pattern is formed when large number of investors starts buying shares again and thus pushing the stock to the highest brink on the chart.
This in turn leads to the question of “an ideal buy point” or “prior area of resistance”.
The important thing to do in such conditions is to stay calm and cut down on the predictions while making your stock move past its buy point on heavy volume.
(4) Buy Point: A buy point usually occurs when the stock breaks through the prior resistance mark.
This is usually called the “ideal buy point” as well.
One of the important things to remember is to be sure of whether the stock can break the barrier of prior resistance on heavy volume before you invest as it would not only reduce your risk considerably but also leave you a lot of space for huge profits.
Market Cycles and Bases
3. The 3 Most Common Yet Profitable Chart Patterns
As part of his book How to Make Money in Stocks, William J. O Neil dealt with the idea of “stocks” and the various intricacies associated with it at length.
One of them was the 7 Step Trading Strategy, the complete report for which can be downloaded here.
In his book William J. O Neil claims that studying common chart patterns of the past century can give a better overview of which stocks will fare well in the future – as he believes stock trends repeat over several decades.
Thus, the three common patterns which are believed to be highly profitable are:
- Cup and Handle (Cups with Handles and Cups without Handles)
- Double Bottom
- Flat Base
1. Cup and Handle Pattern
On bar charts, a pattern resembling a cup with a handle is often termed as a “Cup Handle”.
The cup is in the shape of a “U” and the handle has a slight downward drift.
The right-hand side of the pattern has low trading volume.
Cups with longer and more “U” shaped bottoms are generally seen to indicate stronger signals.
Cups with sharp “V” bottoms and cups that are too deep are mostly to be avoided.
The further the top of the handle is away from the highs, the more significant the breakout needs to be.
It is important to avoid handles that are too deep since the handles should form in the top half of the cup pattern.
Cups without Handles
The cup-without-handle pattern is also called a cup-shaped base.
It is a pattern which is a slightly different take on the cup-with-handle pattern.
As the name implies, the pattern doesn’t have a handle.
It contains all the attributes of a Cup with Handle pattern, except for the buy point.
So, what is the difference?
2. Double Bottom
Double Bottom is a pattern which looks like a lopsided “W”.
It often occurs when the overall market is choppy and volatile and is considered to be a pattern which sets tone for huge price gains in the market.
3. Flat Base
Flat base is usually considered to be a second stage base.
It often occurs after a stock forms a “cup with handle” or “double bottom” pattern.
Flat Base often poses an opportunity to begin a new position or add shares to an existing position.
This pattern shows a milder decline than cup with handle or double bottom pattern and forms a shorter time frame (of a minimum of 5 weeks).
4.Add-On and Alternative Buy Points
Though these three are the main patterns which help you trace the best stocks in the market, it is important to know what additional buying opportunities these stocks offer.
These additional buying opportunities can be used to enhance your existing position or initiate a new one in some cases.
- Less is more: Always look forward to buying a smaller position than you would from a cup with handle, flat base or double bottom, especially if you’re buying shares in a stock you already own. In this case, also make sure that you buy fewer shares than whatever had been purchased in the initial breakout as this keeps the average purchase price in check.
- 3 Weeks Tight: As seen in case of a flat base, this pattern occurs after a stock breaks out, embarks on an uptrend for a bit, then pauses to digest the profits!
As the name implies, it takes only 3 weeks to form.
So, what do you look for in this pattern?
- Each weekly close should be within about 1% of the prior week’s close and this creates the “tight” range as we see it. Always focus on weekly “closing prices” as these indicate institutional investors are holding on to their shares and are quietly accumulating more as they go, hence keeping the stock in a narrow cum tight range.
- Ideal buy point must be 10 % above the peak in the pattern and the Buying range must be up to 5% above the ideal buy point. Here too, it is vital to buy as close as possible to the ideal buy point.
- Volume on day of breakout must be at least 40%-50% above average to show that the investors are diving into the market.
- Bounces off the 10-Week or 50-Day Moving Average Line: after a stock has broken out of a proper chart pattern, it may pull back to the benchmark 10-week or 50-day moving average lines.
If the stock bounces off the moving average line and shoots higher on heavy volume, it can offer a chance to buy shares. That type of behavior shows institutional investors are stepping in to “support” the stock and protect their positions. It happens around these moving average lines simply because professional investors use those lines as key benchmarks.
So, What to Look For In this Pattern?
- Look for light volume on the pullback – This shows professional investors are not aggressively selling shares. Volume may be above average certain days or weeks during the pullback, but overall it should be “drying up” or getting lighter as the stock nears the moving average line.
- Make sure the stock bounces off the moving average line and heads higher on heavy volume – You want the stock to rebound and show strength, not weakness, before you buy. Never buy a stock as it’s moving down.
- Buy as close to the moving average line as possible – As the stock bounces off the 50-day or 10-week moving average line, you want to buy as close to that line as possible. The farther away from the line you buy, the riskier it gets.
- Focus on the first two pullbacks – The best gains typically come from the first two pullbacks to the 10-week or 50-day line. By the time a stock’s third or fourth retreat occurs, it likely has already had a good move. Chances are now higher that the pullback is actually the start of a more serious sell-off.