Part of stock analysis involves undertaking fundamental analysis, technical analysis or a combination of both. Although, it would be nice if everything was as simple as black and white without any inconsistency.
For instance, mathematical measures of intrinsic value like P/E ratios or a stocks price-to-book ratio are not consistently producing winners that outperform in every market.
If scrutinising balance sheets and financial statements provided the biggest edge, accountants would be the best investors.
Even with the technicals, many stock bases have both positive and negative characteristics, often making it unclear as to what action one should take based on the technicals.
There are no certainties in the market, therefore, the only thing we can do is to make decisions that put the probabilities in our favor.
While fundamental analysis can narrow down the superiority of a stock thus separating the wheat from chaff, it’s still not enough to buy a stock that is showing an increase in earnings, revenue or sales growth when price on the stock chart is not confirming that growth story.
To stack the probabilities further means buying a fundamentally sound stock in the right way at the right time.
Adding technical analysis to fundamental analysis allows us to check the supply and demand of the stock. Further, the technical element helps to identify sound price bases which can ultimately determine possible future price movements.
Base patterns such as the cup with handle, double bottoms and flat base have stood the test of time.
Renowned advocates who made their fortunes trading these base patterns include “Box theory” pioneer and best selling author Nicolas Darvas, Investors Business Daily founder William O’neil, three time US Investing Champion and former fund manager David Ryan, and two times US Investing Champion Mark Minervini.
These base patterns stood the test of time because fear and greed are base instincts that drive investor behaviour.
Consequently, history does rhyme where a flat base found on Apple Inc. on the NASDAQ in August 1999 can be mapped over to Gentrack Group Limited in October 2023.
The flat base shown in Gentrack’s chart above is formed when price moves between two defined horizontal trend lines.
Price moving between these lines suggest consolidation or indecision between buyers and sellers. The bottom line can be considered a floor (or support area) whilst the top line can be considered a ceiling (resistance area).
Importantly, if price is stuck in a relatively tight consolidation area between support and resistance, then price can only move in three ways being up, down or continue sideways.
Knowing this gives us perspective on price behaviour and can reveal when a trend is about to begin. In other words, it’s in these consolidation phases where trends are created and born.
At some point, price will eventually break out from a consolidation phase, and this is the moment we have been waiting for. It will either confirm continuation of the current trend or signal a reversal.
Before defining the buy zone, we need to provide some general parameters on how to identify these flat bases:
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How To Identify Flat Bases On A Chart
1) Identify where price has traded back and forth within an easily definable area of support and resistance
2) The minimum length for the base should be no less than 4 weeks
3) The correction in the base (from the top of resistance to the bottom of support) should be no more than 15%
4) The flat base should succeed a previous base (given it’s a trend continuation pattern)
Since this long bias strategy involves entering when the market has sufficient momentum to power through established resistance, the breakout through resistance is our defined buy zone, much like Gentrack’s defined area in the chart above.
There will be occasions where price has traded above resistance one or two times without any follow through the next day. This is not uncommon as not every support and resistance will be so neatly defined.
With this caveat in mind, the level where the majority (95%) of the price is below the resistance line, that is the zone where you want to see your buy signal set up and clear that area.
Incorporating some wiggle room around the buy zone means our entry can be within an area rather than a precise point.
When To Enter
If entering off the daily timeframe, the optimal time to enter would be on a bullish candle breakout, coupled with above average volume, in one single day.
Consider a bullish candle a daily move of 2% and above with little selling pressure. A slight selling wick is negligible (as seen in Gentrack’s chart) if the wick is less than 20% of the entire body of the candle.
Above average volume confirms 1) the breakout is more than likely genuine with 2) an increase in market participation. When viewing Gentrack’s chart, the breakout candle accompanies above average volume spike which is rarely matched when compared to the rest.
For this strategy we always refer to the daily chart and never consider entering beyond the breakout day.
Patience Pays
Importantly, it pays to be patient and wait for the breakout to ensure we have the highest probable set up which has the highest probability of working out.
We want to react when the market gives us confirmation that the breakout is actually happening.
In contrast, if we try and predict the breakout by forcing our opinion on the market with a premature entry, we could be stuck in a position that fails to breakout.
Here we face the risk of being stuck in a consolidation phase for an unknown period. This means funds area tied up in a position where we are losing time.
Even still, if price breaks to the downside, then we also lose value. A premature entry can then cost the investor both time and value.
On the other hand, if we wait for the market to give us confirmation we put the probabilities in our favour to not only increase our win rate but also our reward.
Chasing The Breakout
These general guidelines also suggest not chasing the breakout if it has traded 5% past the buy area, especially for the inexperienced.
Keep in mind, the further your entry is from the buy area, the greater the risk the stock will pull back and re-test previous resistance turned support (which is not uncommon).
Although, a useful tool to assist in organising your entry is the use of price alerts. This common feature found on many platforms allows the user set and receive an alert when price is a couple of percent away from your buy area.
Therefore, the use of price alerts is an excellent organisation tool that can keep you on the right side of the buy area as opposed to chasing price. It also reduces screen time for those who are time sensitive which assists in making the entry process quite stress free.
Tricky Entries in Flat Bases
It should be reminded that just as defining the proper buy zone is not always clear cut, the same can be said for when to enter.
For instance, the flat base breakout on the Wesfarmers chart below is good example where decisions around entries can be tricky.
Wesfarmers broke out of a three-and-a-half-month flat base on December 15 2023 despite price breaching the entry point in the two previous sessions.
Whilst price poked above the buy zone, one of these attempts lacked a bullish candle that accompanied above average volume.
It is important to be aware that price action around the entry area can be messy and to expect intra-day selling. Sush action can both lure impatient traders in whilst also shaking out traders who are fixed on every downtick.
Have A Plan If You Are Wrong
If the stock breaks out then pulls back and closes under the buy zone, this is a good signal that the breakout has failed giving us an easily definable exit point.
Following a breakout, old resistance should act as new support and new support should act as old resistance.
These levels then allow us to determine 1) when a trade has failed and 2) where to set a stop loss order.
Following a breakout, a close below new support level should be used as “the point we are wrong” to close out the position.
With any pattern where a stock breaks out, the pattern alone should not be considered an automatic winner. This is a fallacy for people who are trading off chart patterns. They wrongly assume patterns are no fail systems. Patterns just provide a leading indication of which stocks may be ready to move. We must be prudent and prepare for the failures.
Stacking The Probabilities in Our Favour
There are others decision we can make to stack the probabilities in out favour. For instance, the probability that a stock will breakout and continue trending is greater when the general market is already in an uptrend.
Besides having environmental awareness of the right market trend direction, a stock that has an in-built catalyst such as a positive company announcement or positive financial reporting is arguably the one time where a breakout is more likely to work irrespective of the market direction.
Identify sound bases in the strongest stocks within the strongest sectors also puts the odds in our favour.
Taken together, by identifying positive company announcements of stocks with sound bases from the strongest stocks within the strongest sectors increases the probability of the trade working out.
WiseTech is a Stock To Watch Trading Near A Buy Zone
While the tech sector has weakened of late, it’s still the strongest sector year to date with a number of stocks trading in or near buy zones.
In the first half of 2024, the software provider to the global logistic industry reported total revenue of $500.4 million, representing a $122.2 million or 32% increase on first half 2023.
But it was the 23% increase in EBITDA over the prior corresponding period that exceeded analysts expectations which led price to gap up and close 11% higher end of day.
WiseTech founder and CEO Richard White noted that, “Our highly cash generative business model and strong liquidity continues to provide a solid platform to fund long-term sustainable growth”.
WTC is trading 8% away form a buy zone within a flat base. Price is in a 3 month consolidation within support and resistance in a base that has corrected 10%.
Whether or not WiseTech breaks out it is setting up and certainly one to watch.
The company will host its full year 2024 results on the 21st of August 2024.
