High RS, Low ADX, Flat Base
While sound base formations are rare among the techs these days, I continue to find them among select retail and home builders, industries which respond positively to falling interest rates. I found two decent-looking candidates today using the TradingMarkets StockScanner.
In a moment, I’ll share with you the StockScanner screen I used. But first, let me make a point about pattern recognition.
A number of medium-term traders have written to me saying that they’re having trouble finding cup-with-handle bases in the current environment. Yes, CWH patterns are scarce among the high relative strength stocks. But the problem isn’t that particular base. The problem lies with your pattern repertoire.
The cup-with-handle, a bullish continuation pattern popularized by the legendary trader and Investor’s Business Daily founder William O’Neil, is one of the most effective patterns in the repertoire of the intermediate-term momentum trader.
But don’t become a Johnny One Note. Cup-with-handles tend to proliferate in general market corrections, but at other times are more scarce, a fact observed by two-time U.S. Investing Championship winner and Market Wizard David Ryan in his interview in The Best . While Ryan makes ample use of the cup-with-handle in his medium-term trading, another pattern he seeks out is the flat base. The buy signal comes when the stock breaks out of a consolidation range and moves into new high ground.
In the current market, I’ve found flat bases and kindred patterns much more prevalent among the high relative strength stocks, particularly those in the stronger groups. I find most of my watch-list stocks just by running screens of stocks with high RS scores, then manually eyeballing each chart. However, I’ve recently added a new StockScanner screen to my nightly work which has smoked out a number of uptrending stocks in consolidation phases.
I got the idea from Larry Connors, who suggested screening for stocks with high RS values and low readings on the Average Directional Movement Index (ADX). After some playing around, I set the StockScanner values for equal or greater than 97 for 12- and six-month RS, equal or greater than 90 for three-month RS, and the ADX at equal or less than 20.
The idea here is to catch stocks that have displayed powerful performance relative to general market, then have moved into narrow trading ranges. Not all the stocks generated by the screen will pass muster when I inspect their charts. Here are two that look respectable. For each stock, I’ve provided a long view to evaluate the trend and a more recent view to catch the consolidation pattern.
^BEBE^ is consolidating in a tight range after a months-long prior uptrend confirmed by a rising relative strength line. The Brisbane, Calif.-based company produces a line of contemporary women’s apparel and accessories.
^MTH^ is a too deep — 35% price decline from Jan. 11 peak to Jan. 19 trough — to fit the definition of a flat base. However, it is forming a tightening consolidation zone following a dramatic advance confirmed by the RS line. The stock ran into selling on Feb. 7 and Feb. 8. So it needs to prove itself by continuing to tighten here on declining volume. Some flat bases break out with average volume, but because of the recent selling in Meritage, I would insist that any breakout be accompanied by strong volume.
The top field of all charts in this commentary uses a logarithmic price scale and displays a 50-day price average in red. In cases where the displayed security has traded long enough, the top field also may exhibit a 200-day moving price average in black. In the second field, a blue relative strength line represents the displayed security’s price performance relative to the S&P 500. The third field displays vertical daily volume bars in black with a 50-day moving average in blue for volume.
All stocks, of course, are risky. In any new trade, reduce your risk by limiting your position size and setting a protective price stop where you will sell your new buy or cover your short in case the market turns against you. For an introduction to combining price stops with position sizing, see my lesson, Risky Business. For further treatment of these and related topics, check out the Money Management area of TradingMarkets’ Stocks Education section.