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Chart Smarts for Tough Value Investors Part 2: The Line Short Sellers Love to Watch

By Lynn Carpenter

Dear Reader,

More on how to hear whispers from the market and use charts for more than pretty pictures …

Last week, we started our chart walkthroughs with the trendline investors love - bull support lines.  This week, we’ll carry on with the second of the four types of trendlines. 

It’s the other support line, and it tells a different story.  It’s something of a stealth weapon, too, because it gets so much less attention.  Even technical charting books tend to run past it quickly.  But experienced traders, especially index traders and short sellers, know it well.  We’re getting quite sophisticated now.

This trendline is formally dubbed the “bear support line.”  But if it had a nickname, it would be the “now you should worry” line.

Just to remind you, this is chart reading for investors.  I’m assuming you’ve already made your essential investment decision based on company fundamentals - profits, outlook, product development, and such matters - or your own monetary concerns.  But if you’ve already decided you are interested in buying or selling, this line can help refine your timing for the best potential.  It will also help you hold back from acting when you are most likely to regret it.  

The bear support line - just like last week’s bull support - goes under prices to support them.  It connects low points and tends to hold prices above the level of the trendline, though from your viewpoint as an investor, it may seem to be doing a lousy job.  It doesn’t keep prices from falling.  It merely limits how far down they go.

Let’s look at a real case:

There’s a lot of information on this little chart of Agilent.  First we have to get a bear support line to use.  From October to December, there wasn’t one.  The chart wasn’t quite bearish yet.  But the January 22 low gave us the second point to connect with the November low.  Now it was possible to connect two falling lows to draw the bear support line.

What good is this? Well, if you were holding Agilent stock and thinking about selling it in early February when it was $31 or $32, you might have anticipated its “test” coming up around $30.50.  The stock was bearish by then.  You can see that from its general downward drift.  But it was also above support from the trendline.

As a chart reader, you would have been very much interested in waiting a little longer, because the stock price was likely to hit that bear support line and bounce up.  It wouldn’t have made a great deal of sense to have taken all the pain to that point, then get out at $31 when there was a very strong chance that with just another 50-cent drop, the stock would hit support and rebound.

It did.

Of course, the whole market was horrible this winter, so the bounce didn’t go far.  The stock seemed to weaken again.  You might have anticipated another test would come soon.

And it did.

Look at the area in March that I circled.  The stock hit that bear support again in mid-March, but it didn’t bounce and it didn’t punch through.  It stalled.  This is big information …a very important clue.

Provided there’s no surprise bad news - like Agilent’s CFO running off to Vanuatu with his secretary and the company pension fund - then this chart is reason to hope for improvement.  There is very strong bear support right where the stock is now.  It has not been able to close below that bear support line and continue down the next day.

Areas like this on a bear support line often turn out to be where revivals take root.  From here, the stock has a much better than average chance of turning upward again.

Look at your special report, Embrace the Bear, if you want to understand the psychology here.  Bears are buyers, not just sellers.  But they are waiting to buy at their price, a low one.  The bear support line points to where that price is likely to be.

That’s also key as to why this line often turns out to be the spot for a new bull trend.  On the way down, disappointed bulls are getting out of the stock.  Eventually, all the old bulls have gotten out.  When the stock reaches a point where there’s hardly anyone left to sell and only a bunch of bargain-hunting bears doing the buying, the stock will start to ease upward from the bear support line.  That’s when a new crop of potential bulls - ones who are not scarred with losses from the last time - will see the rising action, get interested, and take the stock higher.

There’s another use for the bear support line, though.  It’s useful to short sellers.  When you short a stock, you sell borrowed shares first, then you buy some shares later to repay the loan and close your trade.  Obviously, you hope to sell high at first and buy low later.  So you want the stock to drop when you’re going short.

Short selling is risky and expensive.  If you want to do it, you need to know how much potential there is in the trade.  Smart short sellers use the bear support line to see what their risk-to-reward looks like.

And since bears are the subject today, what better chart to illustrate this than Build-a-Bear Workshop:

At the points I marked with an X, the price is near the bear support line.  These would have been bad places to make a short trade.  There was little potential drop left – unless the stock crashed through its bear support line.  But in November when the stock was at $18 and bear support was way below at $12, you had a good spot for a short trade.

Something else interesting is going on here, too  If you were to lay another line across all those peaks, you would have a nearly parallel line that showed you where this stock was likely to fail every time it began to rise.

But that’s for next week, when we look at resistance lines. 

Today’s takeaway is that near the bear support line, you are likely to find buying activity pick up.  So don’t short a stock when it’s near bear support.  And if you are thinking of selling a loser when it’s close to this line, you may want to reconsider.  Give it a chance to “test” its support and bounce back up.  If it hits support and continues down, though, consider yourself duly warned that it’s one sorry stock.

Respectfully,

Lynn Carpenter

P.S.  To let me know what you thought of today's article, send an e-mail to: feedback@investorsdailyedge.com.

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Market Watch

How Many Stops Did You Hit this Year?

By Lynn Carpenter

In the early 90s, newsletters began telling people to use trailing stop losses.  And now I hear from people in all parts of the world that they consider themselves to be very responsible about using them.  The most common practice seems to be to sell automatically if a stock falls 25 percent from its most recent high.

Yeah, well a lot of responsible people got hit in the solar plexus this winter following that advice.  Hard.

In the United States, there are nearly 6,000 active stocks (5,663 to be precise) that trade at least 1,000 shares per day on average.  As of Monday’s close, 69 percent of them were at least 25 percent below their 52-week highs.  That was after the market had re-gained 6 percent in a week.  That means millions of stops got triggered.

The worst of it is this: about 70 percent of the stocks that just barely hit their 25-percent trailing stop losses this year are now above the prices where the stop-loss investors folded.  Many of these stocks will not drop to that stop-loss point again.  So thousands of investors took the worst price the market had to offer because they acted automatically instead of mindfully.

There were many reasons why the market fell this winter.  Hordes of investors/traders using their pre-set trailing stop-loss - all aimed at the exact same 25-percnt decline from the high - played a big part, too.  Their intentions were good, but think about it …

If 20 million people all follow an automatic rule to sell a stock once it drops 25 percent from its high, what do you think is going to happen in a bear market?  This triggers massive automatic selling on top of the overall market’s downward drift.  And none of it has anything to do with the company. 

I don’t like one-size-fits-all stop losses.  I never have.  As you have seen from your first two weeks of chart reading, critical areas for a stock may be 15 percent below a high, or 30 percent, or some other percentage.  It depends on the stock.  I consider it better to know what you are doing when selling instead of blindly following a program.

There are two smart ways to sell a stock.  One is to decide how much you definitely want to keep and get out if the stock drops to that number.  It doesn’t need to be 25-percent down.  If you’ve made 100 percent, you may want to keep 90 percent.  Set your stop loss there if that’s the case.

Since there is actually no good fundamental or technical reason to sell at 25-percent down, there’s no advantage in losing that much if you don’t want to.  (There is a “magic” number, perhaps, but it is the Fibonacci number of 38 percent, not 25 percent.  More on that some other day.)

The other way to sell is by informed decision.  Either follow the company fundamentals and stay while they’re good, or use your charts and sell at a place that makes technical sense.

A blind 25-percent stop loss is questionable in a good market, and downright dangerous in a bear market.  But maybe you already know that.

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