Channel Surfing for Fun and Profit
| Stock Selling
Strategies Channel Surfing for Fun and Profit |
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When we speak of channel surfing, we're not talking about trying to avoid reruns of Three's Company on TV. We're talking about monitoring the channels within which a stock is trending. We touched on this earlier in this series with our section on selling when the trend shifts. But we want to elaborate on this a bit.
Trends shift and move in funny ways, so how do you really know if a trend is shifting? How do we know whether a reversal in a downward trend is not just a dead cat bounce? How do we know whether a reversal in an upward trend is not just a correction?
The thing to remember is that stocks prices do not move in a vacuum. Stock prices often anticipate news or events about to happen. This is quite evident when the general market anticipates an interest rate cut and moves up before the event actually happens. Individual stocks are much more subtle. Their price movements often anticipate news that only company insiders are aware of. Later on we read about troubles and the light bulb clicks on - oh yeah, that's why this stock must have gone down.
So with the help of a few handy graphics, we'll elaborate on the types of movements stocks can make.
The above chart shows Calpine's price movements from November 2000 through July 2001. As you can see, Calpine was in an upwards channel from January until mid-May. Drawing roughly parallel lines connecting the outer edges of the stock's fluctuations gives us a price channel.
Some people advocate setting a stop loss on a stock based on your purchase price to cut losses short if the stock turns against you. Numbers vary. William O'Neil suggests around 7%. The Cabot Market Letter advocates 15-20%. While setting a limit to your losses is a good idea, Donald Cassidy, in his book It's When You Sell That Counts, argues against this.
Cassidy suggests that you look at the stock's chart, draw channel lines, and if the stock strays below its channel, you should consider selling. In the example above, Calpine dipped out of its trend and tried twice to break back into it. When it failed the second time and dropped to $50, that was s sign to get out of the stock.
The interesting thing here is that it does not matter how great the company's fundamentals look on paper. Something is spooking investors into selling off, and you're best not to challenge the market. In this case, the sell-off was sparked by concerns that Calpine would not be able to collect huge sums of money owed them by California utilities facing bankruptcy.
If you like the company, its story, and the fundamentals, you can park your money on the sidelines and wait for an opportune moment to buy back in. That point might be occurring at the $38 level where the stock is starting to move horizontally. At this point, one would watch for a clear sign of a reversal and a new uptrend.
Our second chart looks at Qualcomm from January 1999 through July 2001. Qualcomm was one of the best performing stocks of 1999 and as you can see, it rose in a very steady path as indicated by line A. But in late October 1999, the stock took a sharp turn upwards, then leveled off briefly. That jump could have been a blow-off top, but you never want to sell too soon. You'd wait for the stock to reverse. Instead, it shot up once again to peak around January 1, 2000. That was a blow-off top and the stock quickly retreated after that. An aware investor would have sold immediately when it started to drop sharply.
The stock then tried again to climb back and, as shown by line B, there seemed to be a new channel forming. If you had sold shortly after it peaked, you could have been tempted back in by the new channel formation. But it would have been more prudent to wait for the stock to hit new highs again, which it never did. The stock eventually flattened out about the same level as the peak reached with channel A.
The last chart shows Home Capital Group which illustrates perfectly a common occurence with stocks on a long term uptrend. They form a channel, then level off and are flat for a while, neither rising or falling very much. Then they take off again and form a new channel. In this case, the stock moved at a flat level for several months, took a sharp spike upwards, levelled off again and then formed its new upchannel.
The slope of a new channel is not necessarily the same as th earlier slope. In this case it was steeper. As a stock matures, it could move to a more gradual slope.
Types of Channels
Recapping the channels, you can have an upward sloping channel, a downward sloping channel or a flat channel. Channels can change their slopes and become steeper, or they can grow less steep.
Where a channel changes is called an inflection point and the nature of the inflection point determines how an investor should act. If the stock levels out flat, but does not move downwards significantly, the stock can be held, particularly if its recent quarterly report is strong.
If the channel shift into a steeper slope, be aware of the possibility of a blow-off top. This was certainly the case with Qualcomm. I do not think it is the case with Home Capital Group. But if Home Capital were suddenly to accelerate upwards, that would be a danger sign. Instead it seems to be entering another flat period.
And if the stock clearly drifts below its lower channel line as in the case of Calpine above, be prepared to sell quickly if it fails to break back in.
Downside to Selling on Channel Trends
Not all stocks move in clear trend channels. Some just meander all over the place. Thinly traded stocks in particular often form disjointed chart patterns. So look for stocks that have good volume and establish a clear trend.
Summary of Advantages
and Disadvantages
of Selling using Channel Analysis
| Advantages | Disadvantages |
| A useful guide to selling. | Not always easy to discern a trend. |
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