Surging stocks are attracting sold-out bulls to some of the most beaten-down names one the market. But it can be dangerous to swing trade an oversold stock— especially if you end up chasing the price during a melt-up move. If you’re looking to pad your portfolio by trading stocks on the rebound, just follow these three simple rules:

1. Don’t try to catch a falling knife — This is one of the simplest rules of trading any stock, not just bottom-bouncers. Inevitably, an inexperienced trader will find a beaten-down chart and proclaim that the stock couldn’t possibly go any lower.

News flash: it can go lower, and it probably will until the chart tells you otherwise.

You could even justify your speculation with an absurdly low RSI or even fundamental metrics. None of it matters. When investors want to sell, they will sell.

$8.86 and maybe lower — you don’t want to try your luck with this stock…

2. Learn how to spot a Key Reversal — Once you become familiar with bar charts, you should learn crucial reversal day patterns. A reversal day is defined as a day where a stock posts a new low followed by a higher close.

By itself, a reversal day is inconclusive. You would need additional evidence before entering a trade on the long side after identifying a reversal day. A key reversal day, however, is a clearer signal that a change in trend is near.

A key reversal day is identified when a stock makes a new low on the day, then moves to close higher than the previous day’s high.

3. Identify resistance areas — So you’ve found a stock that has shown evidence that it’s ready to bounce off a bottom and move higher. Now, you need to identify where the stock’s new-found trend will most likely slow — or even turn back. Resistance can occur at round numbers, trend lines, or near areas of congestion on charts:

Notice the gap down in early August. This marks an important area of resistance. If you were long this particular stock, it would be wise to watch how the stock reacts to the blue line. If it fails to attempt to fill the gap, it would be wise for the short-term trader to sell and move on to other opportunities…

Simply put, if a stock bumps into resistance and fails to move higher, it could be a good time to take profits off the table.

Sincerely,

Greg Guenthner
Penny Sleuth

3 Immutable Rules for Buying Rebounding Small Caps was originally featured in the Penny Sleuth.

We’ve had a very impressive rally with the market acting a lot healthier than it has in the past. What are some of the healthy signs we are seeing? Well, the market:

1. For the first time in almost a year, didn’t roll over at the first sign of resistance.
2. It tends to close at the top of the daily trading range.
3. It had some very strong days ending with a surge in buying just prior to the close.
4. When the market attempted to reverse Wednesday, it promptly shook it off and closed near the top of the daily trading range.
5. Some stocks are clearing prior resistance and some others are breaking out into new highs and aren’t immediately rolling back over.

All of these signs are what you want to see in a market that is healthy to buy stocks. They also tell us that this rally is different.

Now when we saw the market hit its first level of resistance a week and a half ago, we made the case for going short. At the time, that was the proper position to put ourselves in. After all, every time the market bumped its head on resistance it failed. Secondly, the one real negative about this new rally is that it for the most part has been news driven:

There’s two big questions that have to be answered before we will know if we are on the verge of something real.

1. Is the market capable of rallying without the benefit for news driven events? Healthy markets rally on their own; they aren’t dependent on news events.
2. How is the market going to handle the first pullback of this new leg up?

The market has rallied close to 23% in two weeks and is now at long-term resistance. Take a look at the following charts:

As you can see here, the NASDAQ has formed a V-shaped cup as it has rallied up to an area of long-term resistance. And what did it do when it reached resistance, it started to pullback.

As far as the Dow goes, it has formed a classic short-sell set-up — the pullback off lows pattern. When a stock, or an entire index is locked in a downtrend, it often forms mini-uptrend patterns as the stock or index attempts to make a stand and recover from the selling. Those mini-uptrends are commonly referred to as Pullbacks Off Lows or POL’s for short. When we find these set-ups, we draw a pink line connecting the lows of the most current uptrend. A break below the pink line triggers a trade to the short side. Here too the full stohcastics are well into overbought territory.

Given the above, the percentages favor the market pulling back to consolidate these gains. But the question really is, will we pullback in an orderly fashion (light volume, low volatility) and not undercut the prior lows, or will the pullback be violent, sharp and undercut the lows?

If it’s the latter, then we still have what we’ve had all year — a downtrending, bear market. If the pullback is orderly and doesn’t undercut the recent low, then we have the start of a new uptrend — higher highs, higher lows.

So for now, we have to stay the course with our current positions as the percentages favor us making money in our current positions vs. looking for new stocks to buy after the market has already rallied 23%.

If the pullback is orderly and signals a new uptrending market, then we will use the pullback to close out our short positions and get aggressive at looking for and taking advantage of long set-ups. And our bias will be on the long side until the market tells us otherwise.

IN SUMMARY: From here IF we are going higher in the medium term then what we need to see is an orderly pullback off recent highs that is contained above the 50 day average and resets full stohcastics back into oversold territory. A good example of what we are talking about is the following chart.

Notice how all the pullbacks were contained above the 50 Day Moving Average? Notice how in each case before this issue moved the Full Stohcastics were in oversold territory and staring to curl up before this issue made its move?

Applied to our current market, an orderly pullback will mark a FIRST HIGHER LOW in the indexes which is something we really haven’t seen for quite some time. That’s just how important this pullback is going to be.

Regards,
David Grandey
AllAboutTrends.net

March 30, 2009

Could the Markets Be Ready for the Start of a New Trend? was originally featured in the Penny Sleuth.