In my trading career of seven years I have analyzed thousands of stocks and I analyze hundreds of them every week to trade in my own account. The following article is based on my observation. William Shakespeare in his play “As you like it” said…
“All the world’s a stage,
And all the men and women merely players;
They have their exits and their entrances;
And one man in his time plays many parts,
His acts being seven ages.”
Just like human beings, it can be said that products, corporations, and many other living and non-living entities go through various stages of life. It only stands to reason then that stocks go through various stages in their life too. A stock’s current life cycle stage must be identified by traders/investors if they are to realize significant financial gains through trading in the market.
This aforementioned life cycle is shorter for certain stocks and longer for others. However, all stocks follow the same stages in their life cycle. Whether a stock is completing its upward cycle in price or is on a downward cycle, it usually moves gradually, in baby steps. Thus a stock has various mini-lives within its big life.
And, it can be said, some stocks fall as fast as they run up. This stock movement is similar to a product that becomes a fad overnight. When this type of stock completes a downward cycle it starts moving up. There are some stocks which continue going up with only minor interruptions in their journey. Then they eventually complete a cycle and come back down to some level where they only trade in a narrow range (base). Identifying the life cycle stage of a stock could help traders in adopting the appropriate trading strategy needed to realize potential profits.
Some stock experts (e.g.., market authors) have divided the life cycle of a stock into four phases. These are:
* The Accumulation Phase (Base)
* The Growth Phase
* The Topping Phase
* The Distribution Phase (Decline)
Instead, I have divided the life cycle of a stock into five stages. Every stock, on any given day, is in one of the following stages of its life:
* Basement (oversold)
* Trading range (consolidation)
* Everybody wants it (premium stage)
* Penthouse (overbought)
* Breakout or Breakdown
In the following paragraphs, I will explain the various stages of a stock and its behavior while in each of these stages. To begin with, visualize a high rise building with four levels: the basement, the lower level floors (the bottom half of the building), the higher level floors (the upper half of the building), and the penthouse (the ultimate floor with an outstanding view).
When a stock is in the basement, its price is beaten down and, generally, trading at a very low level. For example, it could be trading below its 200-day moving average. It could also be trading below its book value and, therefore, considered cheap by this standard. The retail investors do not want to buy this stock since there is usually an overwhelming amount of bad news currently associated with this stock. Also, the charts do not show a pretty picture. However, value investors (the smart money) know the stock’s real value and they buy at this deflated price. Then, they hold on to the stock with the belief that the market has overreacted and the current price does not correspond with the company’s long-term fundamentals. Thus, they expect a significant price increase in the near future.
Next, visualize some low level condos (trading range, consolidation phase), some high level condos (everybody wants these condos and are willing to pay a premium price), and a penthouse with a great view that only a few can afford to own such as AAPL these days which is trading at $621. When a stock is making its 52-week high, it is usually in the penthouse and getting expensive compared to its book value. Its P/E ratio is going through the roof but the herd mentality of the traders causes them to keep chasing the stock until there are no shares left to chase; the last man standing, as they say. Therefore, it is very risky to trade a stock that is in the penthouse stage.
Your job, as a trader/investor is to know when a stock is in the basement. For example, these days EDU is in the basement. EDU chart shown below:
When you determine that a stock is in the basement, you then watch the stock on a daily basis as it can make its upward move in a moment’s notice. This upward move could come upon any good news or expected good news. Sometimes the stock starts rallying upon the rumor of a takeover or a buyout.
Therefore, when the stock is in the basement, you have a point of reference as to where to place a stop. This could be below the lowest low of the last two or three weeks of its trading range. EDU made a low of $9.41 when it fell on July 18th, 2012, therefore, stop could be placed below $9.41. Also, whether you purchase the stock outright or buy a long call, you have to watch the trading volume. The current volume should be greater than the average volume of the last two or three weeks. Unless you do not mind holding the shares for a long period of time.
Once the stock makes its upward move, with significant volume, the chances of it going down become less. Some of the candlesticks to look for when the stock is in the basement are Doji, Hammer, and a Piercing pattern. A Doji candle tells us that buyers and sellers are at a stalemate; a hammer candle tells us that buyers are bottom fishing; and a piercing candle is a bullish reversal pattern. If the stock does not make its upward move, and falls below the basement, then it will start a new leg down. For example, if EDU goes below $9.41, give or take 10 cents then it could start a new leg down.This could be a significant move. Therefore, you need to put the stop, as mentioned above, below the recent lowest low.
Once a stock makes its move upward from the basement (oversold area), it could move up fast until it hits its first area of resistance ($14.50 – $15.50 for EDU). It is at this resistance area that the near future price of the stock is decided. There could be some sellers waiting to short the stock at this resistance area, since they are already short the stock, and they wish to cause the stock price to decline further; hoping that the stock will stay below the resistance level. Therefore, these sellers will do their best to bring the price down by shorting the stock. The stock could either pullback severely and drop inside the basement, forming a new leg down, or buyers could come back in before even the stock hits its recent lowest low, thus overcoming the supply from the short sellers, and then the stock moves up aggressively and breaks the resistance to move even higher. This could take numerous sessions to play out. Therefore, it is advised to be on the sideline at this stage, if you are not in the trade already, as you do not know who will win. If you are in the stock or holding a long call, it is suggested you sell, lock gains and wait for the next move either up or down.
Once the stock breaks the first resistance, it will move up fast until all buyers are exhausted in their purchases. This is the time to go long in the stock either via purchase of shares or one strike in the money calls. The stock may run up for next two to three days. After this run up, the stock will trade in a narrow range (consolidation) as selling is absorbed by buying. Some new buyers will come in causing some old buyers to sell to them. But in terms of price move once again there is not any significant move either to upside or downside.
In addition, the stock may be trading just below its very critical 50-day moving average. At this point, if any bad news related to the stock comes out, then the stock will quickly sell-off. The selling could stop right at the support (which was previously resistance) or if this support is broken, then the stock will fall to the door of the basement, which will act as support.
However, if the stock does not stop falling when it reaches the door of the basement, then it will keep on selling and enter inside the basement. After entering the basement it could break the lowest low which it formed about a month ago. At this time, new bottom fishers must step in to buy the stock without the stock breaking the lowest low that it made (look for the low of the previous hammer candle formed, if any). If new buyers do not step in and the lowest low is violated, then those who bought the stock at the lowest low will also give up. This increases the selling pressure, forms a new leg down and the stock enters the Breakdown stage.
On the other hand, if new traders start buying, then the stock will once again start its upward movement to face a new set of resistances. The resistances this time are stronger than before since the stock failed to break these levels in its previous move upward.
Once a stock breaks the trading range (consolidation phase), it moves to a premium stage. This is the stage where the stock is more popular and it is being discussed in the media. Also, the stock may have crossed its 50-day or 20-day moving average or both and/or a major firm may have upgraded the stock. The retail investor starts buying up the stock. In addition, popular trading softwares, will give buy signal. The stock may keep moving up in price as the demand for the stock is higher than the supply.
Finally, the stock reaches the penthouse. It is important to note that those who bought the stock a lot earlier are eager to sell and lock gains. They have great paper gains and they must sell to realize those gains. So, at this stage, the stock pulls out of the penthouse briefly due to selling pressure. The pullback depends upon its Average True Range. Once the pullback is over, the journey begins again and, stock renters the penthouse as the good news in the stock keeps coming.
Once the stock reenters the penthouse, it can move up rather quickly and breakout. However, as a prudent trader/investor, you don’t want to be caught in a stock when it is in the penthouse, having fun, as the stock can start pulling back severely instead of moving upward. This can happen when there is nothing wrong in the stock but overall market is overbought or market is topping out.
One sign of trouble in the stock can be seen via either the Shooting star or Doji candle. Shooting star candle in the penthouse is a dangerous candlestick. The shooting star candle forms when the low and the close price are the same. It was formed because the sellers came in at the top (the high of the day) and started selling. The bears took over the bulls and drove the price down. In other words, when the stock was moving up and being bought by the buyers, these were the last buyers who wanted to buy and now the stock is going down in price on the day of their purchases. The loss could be significant depending upon when they bought that day. If the stock drifts lower on the next day, and goes below the low of yesterday, then traders will panic and start selling before their losses reach a point of intolerance.
Therefore, when the stock is in the penthouse, traders need to know if the stock will continue its upward journey to the moon or if the stock will break the support and fall big. A stock can spend three to five days in the penthouse and go through a consolidation stage, just like it did when it broke out of the basement and moved up. After the consolidation is over, the stock will make its next move. The chances are fifty-fifty as to what it will do next. If the stock is breaking out, to a higher level, then the volume should be above average. If there is positive breaking news, then other stocks in the same industry group should be moving up, in harmony. The trader must determine if the breakout is genuine, clean, and decisive.
On the other hand, some stocks fall from the penthouse and keep drifting lower and lower, every other day. On a weekly basis, these stocks are forming a new low. Suddenly, negative news emerges on the stock or there is a big seller who starts dumping the stock. Lot of times the stock starts going down even there is no negative news. If you try to find the negative news that the seller is reacting to, you will be unsuccessful. Most of the time, this big seller is dumping the stock as he knows about the upcoming negative news (e.g.., “breaking news” on CNBC). This seller is an “Insider.” The general public is not aware of this breaking news yet as it has not been on CNBC. The news could be anything from an impending lawsuit, a suspicion of fraud, an accounting issue, or a key staff member deciding to leave the company or is sick and/or dying.
When the stock is falling, some traders will consider it as a pullback (which is not the case) and consider it nothing to worry about. However, smart traders need to evaluate the volume or buy/sell pressure and determine what is going on. It could be that the stock is in distribution phase now.
In option trading, this is the best time to buy Puts on the stock and ride it down. In two to three sessions, the stock will fall quite significantly (fifty percent of the previous move from low to the high) thus giving the Long Put holder an impressive rate of return on his investment. The smart trader will determine the stock’s key support levels in advance. There could be more than one support level on its way down. The key support levels, when the stock is going down, could be the 50-day moving average (this moving average is way above the basement) or the 200-day moving average. It could be some Fibonacci level or it could be some secret price point which is not evident to the majority of traders. The point is that there is an ultimate support price and, after hitting that price, the stock will refuse to go lower. No matter how bad additional news may be, no matter what the stock pundits say in the media or in their Blog, no matter what technical analysis indicates, the stock will refuse to go down and it will stay above a certain price point.
The reason is that there is a big buyer buying the stock gradually since he knows the “real” worth of the stock. You can call him the “Insider.” He was the one who sold earlier or shorted the stock and now he is the one who is buying the same stock, whereas general public is busy in shorting the stock unsuccessfully. Even if the stock goes lower, it will close at or above this certain price. This is another indication that the stock has finished its downward move and is now going for consolidation at the bottom.
Knowing this price support is the key to making the most out of your short or Put trade. It is especially critical to know these support levels when a trader is holding onto a Put since these levels will determine how much return he will make on his investment. If the stock hits the support level, and then bounces upward a few points, significant gains will evaporate. On top of this, if the market rallies, then the stock may move up further (dead cat bounce) and time decay, on the Put option, will work against the trader. Therefore, it is prudent to know in advance the key support level that the trader would consider that the game is over and it is time to look for another similar opportunity.
Once the stock has reached the stage of its life where it is considered oversold and is resting in the basement, the fate of its life will be determined in the near future. It either will start rising upward gradually, by following the phenomenon described above, or it will take another plunge downward (breakdown). When the time comes, the trader should be ready to grab the opportunity and go either long or short, depending upon what the stock is doing.
At times, the stock suddenly rises from the basement and just keep going upward as a response to very good news. There may be a new contract awarded to the company or a government policy suddenly favors the company or the company receives FDA approval for a drug. The stock could become such an overnight favorite that its price crosses the trading range, the premium stage, and reaches the penthouse in a matter of three to four sessions. The trading volume is huge and it keeps on rising every day. Some traders make lot of money on this stock as they were not the last one to buy. Some traders end up losing a fortune chasing this stock while it is about to make a U-turn.
Once again to quote Shakespeare from his play “As you like it”
Last scene of all,
That ends this strange eventful history,
Is second childishness and mere oblivion,
Sans teeth, sans eyes, sans taste, sans everything.
Similarly some mighty stocks of yesterday and today such as ANR, BBY, FSLR, GMCR, NOK, RIMM, YHOO and ZNGA may wither away into oblivion tomorrow or rise from basement and reach the penthouse once again where they came from. Time will tell!
Some buying pressure is needed in RIMM. If RIMM fails to cross 18.80 then it would become short candidate.
The jury is still out. I will watch RIMM for next few days.
RIMM chart shown.