Recently, we’ve seen the market roll to the downside, causing those of us who like to go “bottom-fishing” to smack our lips. Yes, indeed, tasty profits can be gleaned from quality companies that get thrown overboard when market players go on a selling spree.
Still, over the years—and I’ve done this myself in my early days of trading—I’ve seen traders and investors make a big mistake that can be detrimental to their wealth.
It goes like this: First, we see a stock (or ETF) trading in a downtrend on a daily price chart, falling in lower highs and lower lows. Next, perhaps after a particularly painful pullback, we see the stock perk up, and even rally for a couple of days.
Aha! We think. Here’s my big chance! We pounce, purchasing a plump position. Then we prop our feet up on our desk and wait for our bad boy to bring home the gains.
Maybe it does . . .
Or maybe it loses its newfound upside momentum . . . wobbles for a day or so . . . and then gets pummeled by sellers. Ouch!
Now, please know that “buying the dip” along with a similar strategy known as “bottom fishing” are two of my favorite tactics. But I have established a set of criteria from which I operate. My target stocks and ETFs must meet those criteria before I plunk down my money. (Of course, after I enter a trade, I switch to my money management rules. I’ll talk more about them later.)
At the top of my list of entry criteria is a simple, but important rule: Check for “prior support.” That means I bring up a long-term chart, either weekly or monthly, and check to see if the stock price was supported (think held up) by market participants (buyers) at an earlier time.
If we look at the daily chart of the Entergy Corp. (ETR), below, we see that the electric utilities company moved to a July 2014 high of $82.48. Then it dipped sharply to its August low of $70.70. When it began to consolidate at about $71, and even made a quick double bottom pattern (highlighted), it looked like a potentially good time to “buy the dip.”
Entergy Corp. (ETR) Daily Chart
Chart courtesy RealTick
Still, I must follow my entry criteria. In this case, I brought up a weekly chart of ETR. When we check out this chart, below, we see that the stock’s recent pullback and attractive double bottom (bottom-reversal pattern) was being supported by $71 – $72 price action that formed in October 2012, April 2013 and July 2013.
Entergy Corp. (ETR) Weekly Chart
Chart courtesy RealTick
Now, note that in April of 2014, ETR climbed above the prior $71-$72 price resistance level. We know that when price moves above previous resistance, then that resistance can act as support.
My evaluation: ETR showed substantial prior price activity at the $71-$72 level that may act as support (buyers). I checked off my first rule of my entry criteria—prior support confirmed.
Fast-forward to the present. If you flip back to the daily chart, you can see that indeed, ETR reversed from our highlighted dip, or pullback, and headed higher (blue arrow), quickly rising above its 20-day moving average (red) and heading back toward $78—so far a dandy trade.
Even so, we all know the reverse can happen. In volatile market environments, the best companies can roll over and get pummeled by sellers.
So let’s be wise. When we look to “buy the dip” or go “bottom fishing,” we first establish a well-thought-out list of entry criteria or rules. And our conditions must be met before we purchase a position, prop our feet up on our desk, and wait for fat profits.
Until next time, keep green on your screen!