How to Find Bottoming Stocks
The words “Buy low, sell high” make me cringe.
That phrase is one of those platitudes that too many investors like to spout off like it’s some sort of market wisdom. Sure, buying low and selling high is what you want to do, but it doesn’t tell you how to do it. Today, we’ll tackle the how.
Earlier this month, I showed you the “sell high” part of the equation (click here if you missed it) — so today, I want to give you some pointers on how to “buy low.”
This week, we got this question from a Trend Playbook reader:
“In an earlier Trend Playbook, you had a quick way to screen for stocks breaking out to new highs. I have been using that method, but… is there a good way to screen for stocks making a nice bottom? I would love to see that addressed in a future Trend Playbook.”
You bet. Spotting bottoms can be tricky, but if you keep a few rules in mind, it becomes a lot easier. Before I get to screening, here’s what you need to know about the anatomy of a stock bottom…
Anatomy of a Stock Bottom
For starters, remember that you’re not trying to “bottom tick” a stock. In other words, you’re not trying to buy at the absolute lowest price and hold on as shares move higher — that’s a recipe for losses. Instead, you want to buy after the stock bottoms and then hold on as shares move higher.
The chart of our Research In Motion (NASDAQ:RIMM) trade Greg showed you on Monday does a good job of showing you what I mean:
With RIMM, you can see that we didn’t buy at the absolute bottom. Instead, we bought higher up. It’s not that we didn’t want those extra gains — the stock just wasn’t a high-probability trade until we pulled the trigger. So what makes it a high-probability trade?
First, the stock has to start out in a downtrend. That’s obvious — a stock can’t bottom if it’s not going down, right?
But you don’t want to buy the stock while it’s still in the downtrend. Instead, it’s critical to wait for some sort of basing action. In RIMM’s case, shares started basing in July, when it started trading sideways. While it was basing, RIMM showed strong resistance at $8.50, a price that acted like a “ceiling” for shares. In the chart above, you can see how every time RIMM approached that $8.50 level, sellers smacked prices back down.
The breakout above $8.50 was our buy signal. It indicated that buying pressure overwhelmed all the remaining sellers at $8.50. Remember, the best time to buy a stock is when sellers are on their backs. Until that breakout happened, RIMM was still in a downtrend.
Once you’ve got the anatomy of a stock bottom in mind, spotting one becomes much easier…
The way I see it, there are three main ways to find chart setups: Look at all the charts in your investment universe, and use math to screen charts manually or use a pre-made screener. While the first two methods are the most effective ways to find all of the opportunities out there, for most investors, they’re just way too time-consuming.
That’s why I’d recommend using Finviz.com, a great free technical screening tool that we’ve talked about before.
To find bottoming stocks, there are a few different criteria I’d recommend plugging in. First off, you’ll want to set your investment universe — after all, for most investors, it makes the most sense to focus on larger stocks that are more heavily traded. So you can specify that by visiting Finviz and clicking the “Screener” menu link and then selecting the market capitalization filter you want to use.
Here, I’m looking at only stocks with a market cap above $2 billion:
Finally, select your “Signal” to look for bottoming stocks. In Finviz, all of the coding and conditions for different technical conditions are done for you behind the scenes, and their system is actually very good at spotting technical patterns. When you’re deciding which signals to use, keep in mind the anatomy of a stock bottom I showed you earlier.
Here’s a screenshot of what the “Signal” selection area looks like:
The most useful signals for spotting bottoms on Finviz include the Double Bottom, Multiple Bottom, Channel Down and Triangle Ascending. Remember, you’re looking for charts that have been in a downtrend and then started basing with a well-defined resistance level. When that resistance level gets taken out, you’ve got a buy signal.
Finally, remember that when you’re looking for bottoms in stocks, it’s crucial to manage your risks with a stop-loss. You’re looking at stocks that have been falling hard, after all, so they may continue moving lower if the increasing buying sentiment wears off. In most cases, I like keeping a stop just below the bottom of the base area.
With Mr. Market coming off of a correction right now, there are a considerable number of individual stocks coming off of bottoms as I write. That should provide more than a few trading opportunities in the next month or so using this approach…
Jonas Elmerraji, CMT
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