Enron, Worldcom and Tyco have provided material for some intriguing case studies on how company fundamentals can be misleading. On the surface, all three of these companies had very impressive annual reports and financial statements with clean audit opinions. However, under the surface, as we found out later, these companies were perpetrating frauds of epic proportions. The lesson here was that you can’t completely trust company fundamentals. So, what can you do to improve your chances of finding tomorrow’s hot stocks? The answer lies in the tea leaves of stock market prognostication, charts.
Charting, also known as Technical Analysis, is the practice of using historical stock market data to predict future movements. It’s based on the theory that over the course of time, certain patterns have emerged and that these patterns are pre-cursors to predictable future events. Is this a better technique than combing through a company’s financial statements? The Efficient Market Hypothesis and Random Walk Theory would say that charting is no better at predicting future stock price movements than fundamental analysis. However, we are firm believers in charting and have had considerable success with it in our trading over the last 20+ years.
Let’s look at some of the basic charting techniques that we use on a daily basis to mine for tomorrow’s hot stocks:
Resistance – the general concept of resistance is that it’s a price level that a stock approaches but does not exceed, and that when it does go beyond that level, it will keep rising until it finds another resistance level. When you’re studying charts for stocks on which you’d like to be long, focus on the small recurring peaks and accompanying declines. As you can see from the EBAY example below, there is a level of resistance at $32 from the middle of December 2011 to February 2012. The way we would have traded this would have been to go short every time the price approached $32. We would have been right three times and once the stock broke through the resistance in February, we would have hit our stop-loss at $33.Our three gains would have made up for the one loss and provided us with a solid overall profit.
Support – hot stocks don’t necessarily have to be those that you expect to increase in price. If you’re a short player, you’ll want to have stocks that will obviously drop in value. Therefore, the use of support analysis would be useful. The concept here is the opposite of resistance, whereby you want to identify price points at which stocks are about to fall through but do not. There could be a number of reasons why a stock would have support but when you’re a technical trader, those reasons are generally not important. What is important is finding the support level and the likelihood of the stock breaking through. As you can see in the GOOG chart below, there was a level of support at $560 between June and July of this year. The play here would have been to go long each time the price approached $560 (with a stop-loss at $550). We would have had two minor gains and if we wanted to let the trade play out over 90 days, we would have had a spectacular run-up to over $700.
Charting can be an extremely useful tool when trying to find tomorrow’s hot stocks. What we’ve shown you in the examples above is an extremely simplified view of how charting works. In practice, we use a combination of these and many other, more advanced and highly effective techniques to come up with our trades. It’s a sort of proprietary secret sauce that we have perfected over time. After all, if picking winners was as easy as looking at peaks and valleys on a simple chart, wouldn’t everyone be rich?