Q: Do you have any tips on how to tell which cup-shaped bases that have distribution on their left sides will ultimately be able to break out and advance meaningfully?
G: There are no hard and fast rules on this. Remember that it is normal for stocks to get hit on pretty good volume once they’ve run up a bit, and usually this is dependent upon the state of the general market. The key, however, is that once you see the heavy volume on the left side, you want to see how the stock acts after that. Does it stabilize? Does it get volume support? Does the selling dissipate? If the selling dissipates, you might see the stock stabilize and hold tight even if volume is not necessarily picking up. Once the stock has stabilized, builds a new base, and breaks out again, I think it is okay to buy the breakout using your stop-loss rules. But you will actually find that a lot of stocks that look “ugly” on the left sides of their bases will absorb the selling, set up again, and then go higher. I don’t think you can really tell if heavy downside volume in the left side of a base is a negative. In stocks with very strong fundamentals, all this ends up doing is shaking out weak hands and bringing in strong hands. It’s the action AFTER the heavy downside volume as the stock stabilizes and builds a new base as well as the volume on the ensuing breakout that matters most to me.
Notice how Research in Motion (RIMM) in early March 2007 and then again in early April 2007 got hit twice on heavy volume, but then the stock held tight as volume diminished. Note that the breakout attempt on the week of 4/6/07 occurred on light weekly volume and failed. But the breakout that occurred on the week of 5/11/07 had strong above-average volume and it worked.
Crocs (CROX) did the same thing and broke out on above-average volume the week of January 12, 2007 but the general market went into a correction and CROX came down with it, forming a new base that was a cup-with-handle with a “wedging” handle that worked. I think the key is to watch the breakout volume when a stock comes out of a base with heavy downside volume on the left side.
Q: What is the “three waves down” principle?
G: This is, to some extent, a corollary to The Rule of Three, something that is in fact observable in a number of situations. The Rule of Three may be applied when we see a stock, on the weekly chart, put in three clear downtrends or “legs down” within an overall downside move that bottoms out after the third leg down. Usually by the third leg down everyone who is going to sell has already sold. If the general market is showing positive action, these patterns can sometimes be bought. Obviously, you maintain your stop-loss discipline on any stock you buy, and there is no guarantee the pattern will work. But if the stock can get moving the upside moves can be explosive. One example is Excel Maritime Carriers (EXM) from the October 2007 top and into 2008.
Q: I am new to investing. I have a question regarding volume. I am getting confused about big volume, low volume, and other characteristics of volume that you describe in your commentary.
G: When I speak of heavy volume, I am referring to volume that is in excess of 125% of average daily volume on a daily chart, and on a weekly chart volume that is just higher than average weekly volume.
Q: When the market is in a downtrend, would you consider buying a stock before we had a follow-through day in the averages?
G: If a stock is showing strong action on a breakout, or appears to be at a logical pullback point, I might consider buying the stock before a follow-through day, with one eye on the exit door.
Q: Usually the 50-day moving average and the 10-week moving average are a bit apart from each other. But when they are further apart than that, which do you lend more credit to?
G: I would watch both moving averages. Sometimes a stock bounces off the 50-day, sometimes the 10-week, so when the stock is close to either is the time I’m looking at buying them. Either way, I’m not quibbling over a point or two when I’m trying to find a stock that is potentially going to have a bigger move.
Q: I see that some stocks once they break out of a base follow the 10-day moving average. What are your thoughts on this?
G: Stocks hold above the 10-day moving average until they don’t. I don’t consider it a useful area of support, other than that a stock that continues to hold above its 10-day as it breaks out and continues higher is showing exceptional strength. So it can be looked at as a measure of power and strength. Eventually, however, it will drop below the 10-day, and may even pullback to the 50-day, but that doesn’t really mean anything to me. On a short-term basis, I do like to use the 20-day as a place to add to strongly-performing stocks. I know a lot of people use the 21-day because 21 is a Fibonacci number, but I’m trying to get the jump on ’em so I use the 20-day!
Q: How many stocks is it best to watch?
G: I think that depends on the person. Success in the market is often achieved by understanding what works best for YOU.
Q: When you recommend. to buy a stock, what if earnings are coming out soon on it? Do you go ahead in spite of that?
G: The bottom line is where you are with your overall portfolio and the stock in question. If you are up 15%-20% in your portfolio, then you can withstand a potential earnings hit if you scale the position properly.
Q: Can you elaborate more specifically as to how you apply stops once the stock has a profit?
G: I take 20% profits if a stock takes four weeks or more to run up 20% or more. I then watch the stock to see if it builds another base. If a stock goes up 20% in two to three weeks or less, I hold it for eight weeks at a minimum, since it is showing extreme power and I may have a big winner on my hands. That is textbook O’Neil. I do not use trailing stops since winning stocks can pull back 10%-12% as a normal course of their uptrends. In general, I stay with a stock as long as it acts well, and may trade around a core position in order to give myself some psychological comfort. I am not a fan of mechanical “trailing stops” and take more of a right-brained approach to figuring out when a stock has run its course. Since my methodology indicates that I am trying to find big-winning stocks, I am not so interested in taking little profits along the way, necessarily. If I buy a breakout and it doesn’t seem to be getting any thrust to the upside, I often just sell it, and if it starts to show strength again I may come back to it. Also, I usually don’t wait for the 7%-8% downside stop when taking an initial position. Two to three percent is often it for me, and if the stock does turn around and start up again I’ll just buy it back.
Q: I got spanked big on a trade in April and I’m scared to death to make a trade which caused me to miss great moves on the stocks I watch like SOL and your recommendations. I follow the Bill O’Neil methods and always use a 6-8% stop which caused me some pain with March and April swings. I’m just about ready to give up and I really don’t want to but I’m terrified to lose again.
G: Fear is a powerful emotion, and it sounds like it has a strong grip on you. Bill O’Neil taught me a primary lesson: “Never operate from a position of fear.” I would suggest paper trading for a while to re-build your confidence. You simply cannot invest in the markets if you are operating from a position of fear, and I urge you to conquer it, because not only will it help you to learn to invest successfully but it will also help in every day life. I believe that the emotions and foibles that we all exhibit in our day-to-day lives as humans, even people like myself and Bill O’Neil whom I worked with for over eight years, can often be magnified in the stock market. By learning to conquer them in the stock market we thereby improve our personal lives.