Drops and Pops
Stockscores.com Perspectives for the week ending July 6, 2008
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In this week's issue:
Does the way a stock trades affect your decision to buy it? Suppose you got a tip on a stock with some really compelling reasons for buying. If you watched the stock for a few days and saw it go down, would you buy it? What if it had been going up while you watched it?
Most amateur traders tend to be swayed by upticks. They look for the market to confirm what they have heard before they buy which means theY take positions when the stock is showing strength. If the stock is on sale, they stay away.
Pro traders do the opposite, they buy strong stocks when they show weakness and sell in to strength. Some refer to this as buying the drops and selling the pops. But there are some guidelines that the aspiring pro needs to understand before they try to trade this way.
Most important, it is not enough to buy a stock because it is going down. Buying a crappy stock that is on sale is totally different than buying one that has upward momentum but is on a pull back.
Good stocks will have times of weakness because some traders want to take profits. The stock runs up too fast and moves away from its trend line. This sets up for a pull back to the trend line that will usually shake a few traders out of the stock. The market is always working to take emotional investors out of profitable trades.
So, buying drops and selling pops first requires that there is some optimism in the market. You need to find stocks that are in upward trends and are going through some emotional gyrations. Upward trends are almost always linear so you should be able to draw a line across the lows on the stock chart to define the upward trend line.
When the stock runs away from the trend line, you have emotional buying that is causing traders to pay too much for the stock. This takes the stock out of a linear up trend to an upward curve. Curves usually correct back to the trend line so pro traders will tend to sell these pops.
This brings the drop, a short term down trend that takes the stock back to the upward trend line. Traders who do not consider the long term trend may get taken out of their stock because of fear, thinking that the slide in price is setting up for more weakness in the future. Many times, the stock bounces and resumes its upward trend when it comes back to the upward trend line.
So, if you like a company, wait for a pull back to the trend to buy it. If the stock is showing too much strength and has run far above the trend line, there is a good chance it will correct soon. Most of the time, chasing stocks is a bad idea.
I once heard a pro trader say that he knew he was doing the right thing if it felt like a hard thing to do. Buying strong stocks on weakness is unnerving because you are watching it go down and there is usually a pessimistic feeling about the stock in the market. But, usually the upward momentum will carry the stock out of that pessimism and allow it to resume the long term trend.
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Let's apply the concept of selling pops and buying dips to one of the strongest momentum stocks of the past few years, Potash Corp (POT, T.POT). Here is the exercise for you to do.
Step 1 - print out a one year chart of POT.
Step 2 - define the trend lines. Draw a line across the bottoms made mid August and mid November and let it carry forward.
Notice how the market ran away from the trend line in December and January and then suffered a strong pull back to the trend line late in January.
Now, do the same thing for the last six months, draw a line across the January low and the low of the pull back in mid March. Let that line carry forward to the end of the year.
Again, notice how the pull back from the April strength came back to the trend line by the end of May. The market again ran away from the trend line in June and has now pulled back as of Thursday.
Does this mean that the stock will bounce higher from here? Nothing is certain, but the probabilities are favorable.
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1. T.POT
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References
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Disclaimer
This is not an investment advisory, and should not be used to make
investment decisions. Information in Stockscores Perspectives is often
opinionated and should be considered for information purposes only. No
stock exchange anywhere has approved or disapproved of the information
contained herein. There is no express or implied solicitation to buy or
sell securities. The writers and editors of Perspectives may have positions
in the stocks discussed above and may trade in the stocks mentioned. Don't
consider buying or selling any stock without conducting your own due diligence.
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