From the desk of Tom Bruni @BruniCharting
The news broke last night that Twitter will be replacing Monsanto in the S&P 500 on June 7th. This announcement comes at a time where Twitter is hitting 3-year highs and is trending higher with the rest of the social media stocks and tech sector. The stock is still down 49% from its all-time highs hit in 2013 and was the butt of Wall Street’s jokes not too long ago, but its recent run presents a great opportunity to study what characteristics to look for when trying to pick a bottom in a stock, the responsible way.
The first step in this process is to identify a shitty stock, but don’t worry, that’s the easy part. There are lots of them. In Twitter’s case it foot the bill because it fell roughly 82% over the course of 535 trading days, or 2.5 yrs.
Step two is to wait for the stock to develop a well-defined range. It’s within this consolidation that the market with either scare out or wear out longs and bring in additional short-sellers. The stock may gyrate wildly, as Twitter did within its ~45% range, but eventually the bad earnings reports, analyst downgrades, etc. will become less and less detrimental to the stock price until finally the stock doesn’t react at all or actually rallies in the face of it.
Step three is to continue to watch the stock and wait for it to break out of the well-defined range it’s been trading in. The longer it’s been trading in that range the more intense the breakout is likely to be, as more longs and shorts get caught on the wrong side of the trade. In some cases the breakout may occur with a strong breakaway gap like Twitter’s on an earnings announcement or other news, but other times it may just break out normally. What’s important is that it’s at this point when prices make a new high, the 200-day moving average is sloping higher, and momentum is in a bullish range that the reward/risk and probability of success are finally ridiculously skewed in our favor.
The Bottom Line: If you’re going to pick bottoms, there has to be a risk management process in place and one of the best ways to set yourself up for success is to identify a breakout from a long-term base that marks the beginning of a new trend.
While this strategy guarantees you won’t bottom tick the stock, it also guarantees you’ll manage risk responsibly and likely catch the majority of the new trend that’s developed, and those are the things we care about.