Monday, February 13, 2012

A Problematic Area for Traders: Stock Bottoms

MetaStock SPRS Series - Week 55 - TechniTrader® Stock Discussion for MetaStock Users: MPWR - February 13, 2012
By: Martha Stokes C.M.T.

This week I want to focus on an area that can cause problems for many traders as stocks complete or move out of bottoms. This is especially problematic on the short term and intermediate term bottom.

Let's first define what constitutes a "completed bottom."

A completed bottom is when a stock has overcome the first major resistance level and has risen in price above that resistance level, AND has been able to sustain that price gain without falling back down below the resistance.

MPWR is our stock for this week. We are studying this stock because it has formed a typical bottom formation recently.

What happens for most stocks as they trend down for a period of time is the first attempt at a bottom fails. This is very common. We can see that in March of 2011, this stock made a decisive attempt to bottom. It dropped to a lower low and then attempted to rise above the downtrend peak of November 2010. However, it failed to overcome this primary resistance level. MPWR proceeded then to move deeper into a much steeper and more defined bottom. You can see that the distribution continued heavily in December – February 2011, but in May- August the distribution pattern wanes, indicating early on that sellers have been depleted. This paves the way for the "shift of sentiment" on TTQA TechniTrader® Quiet Accumulation that we have discussed before. This occurs in October as heavy accumulation commences. What we see is a stock that runs up a few points, then sells down due to novice sell shorters thinking this is merely a bounce. Since most traders do not use accumulation/distribution indicators, they can't SEE that the shift of sentiment has occurred. So they are selling against the tide of institutional buyers. This causes some panic and the stock climbs vertically as buyers continue buying and sell shorters try to cover their shorts quickly. The stock continues to move with momentum energy during December with minor retracements and consolidations as it moves up.

Chart 1

In late January, the stock attempts to test the strength of the resistance level from the prior failed bottoming highs. These highs are where the true bottom completes. This is where the stock defines if it has sufficient buyers to push on through and continue an uptrend over time.

The lower line I have drawn around 12.50 is not where a bottom completes. This is the volatile area where the shift of sentiment occurs. This is where smaller lot traders selling short get whacked by big funds moving in quietly buying the stock as it moves sideways. Since these big funds prefer to control their entry price, the sideways action occurs. Then the stock gets noticed by HFTs and other pros, and the momentum runs occur.

Now the stock is at a crossroads. It must move above the resistance highs of the failed bottom and then hold and maintain those gains for a true bottom to be completed.

Many retail traders make the mistake of thinking the bottom is complete on the first momentum run. It is not. This stock could dip down to retest the support level from that initial move out of the extreme low.

Once the stock has completed the bottom, the trendline pattern will change again as a new group of buyers will begin to dominate as it begins its true trend. But for now, the bottom is not complete and a retest could occur.

If you are a swing trader, you can trade the shift of sentiment momentum runs. If you are a position trader, you must consider waiting until the bottom completes; otherwise, you must keep a very wide stop loss to avoid being taken out at a loss, only to watch the stock move up and begin its trend.

Learning to properly identify when a bottom is complete helps both swing and position traders enter stronger stocks that will move well for longer periods of time.

Trying to trade while the stock is retesting, shifting sideways and is volatile as it bounces around the resistance of the failed bottom high, tends to create more losses than gains. Always use the best entry for maximum profits. Do not worry about 1-2 points. Focus on the entry that will net the highest profits with the lowest risk. Trying to buy a stock that has not completed the bottom is a significantly higher risk.

Trade wisely,

Martha Stokes, C.M.T.
Member of Market Technicians Association
Master Rated Technical Analyst: Decisions Unlimited, Inc.
Instructor and Developer of TechniTrader® Stock Market Courses
MetaStock Partner

©2012 Decisions Unlimited, Inc.

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