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By Tony Golan
Chief Technical Analyst
StockProfit.com™
We've all been there before. You find out about an exciting stock. Everything sounds good about it, so you buy it, and then nothing happens. You proceed to watch as the stock all of a sudden falls asleep and starts to consolidate up and down a little, and goes nowhere for the longest time. Eventually, you get tired of it and sell it, only to watch it then run up like crazy. Or it could be worse. It could gap down on you.
To me, two of the worst things that could happen to you in the market is getting into stocks that go nowhere, and getting into stocks that gap down. Getting into stocks that go down a lot, but over a long period of time isn't as bad, because you then only have yourself to blame for not getting out as the loss continued to get bigger and bigger.
Getting into stocks that go nowhere is mentally and emotionally exhausting, especially if you actively watch the stocks to try and time your entry into and exit out of the stocks. Your money sits there doing nothing, the stock moves very little every day, then when you start to think that it might be starting to move, it turns back down and starts to consolidate sideways. Flat stocks cause you to second-guess yourself, and it gets even worse for people who don't have clearly-defined trading plans (most people don't).
Getting into stocks that gap-down is a disaster. If the gap is not that big, many people are tempted to stay in, and continue to wish they had sold at higher prices as prices continue to go lower (or gap lower). If the gap is big, well, there's your big loss and you didn't even have a chance to get out.
Another pitfall of gap-downs is that stop-loss orders don't protect you from a gap-down. If, for example, XYZ trades at 45, and you have a sell-stop at 42, and bad news comes out before the market opens, and the stock opens at 30, your sell-stop will be executed at 30, not at 42.
I'm sure you heard the adage "Cut your losses short and let the winners run". I'm sure you can see how it would be hard to let profits run when a stock is stuck in a $2 trading range for months, and it would be just as difficult to keep your losses small if your stocks are going to gap-down on you.
So, it seems like the ideal stock will go up a lot and sustain the up-trend over long periods of time, will not spend endless amounts of time consolidating sideways after you get in, and will not gap-down on you disastrously.
How do we find stocks like these?
The 200-day moving average acts as something of a "price magnet". When stocks get close to it, they tend to stagnate and consolidate near the 200-day moving average. Since a 200-day moving average contains the closes for the last 200 days, it is slow to react when the stock starts to soar away from it. The speed at which the stock distances itself from the 200-day moving average is the best indication of the onset of a new up-trend, one which is likely to last for months if not years and the longer the trend continues, the bigger the price percentage gain is and the more money you make.
Chart 1 - JADE
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The chart above illustrates what I'm talking about. For most of 2006, JADE went sideways between 3.50 and 4.60, (marked by the horizontal blue lines on the chart), swinging above and below the 200-day moving average (the red line on the chart), but stayed in the same tight range for a year. Then, in mid-January of this year, JADE took off and started to rally. Now it started to distance itself from the 200-day moving average, and in the next month and a half JADE went from 5 to 12.50, and it's probably going higher. JADE went from non-trending to strongly trending. The only difference is the timing. There is a good time to be in JADE (when it is trending up and away from the 200-day moving average) and there is a time to not be in JADE (when it is twisting and turning endlessly around the 200-day moving average).
The same holds true for any stock. However, some stocks move faster than others. The faster-moving stocks offer bigger percentage gains over the same period of time than the slow-moving stocks. Another problem is slow-moving stocks, again, are the fact that they tend to gap-down disastrously with no warning.
How do we differentiate between slow-moving stocks that are in up-trends and the super-performers?
It is exactly for this purpose that I developed my Relative Strength Differential (RSD) indicator. Relative Strength Differential measures the speed of the up-trend in the way a stock outperforms the S&P 500, and assigns these up-trends a percentage figure. If that figure is above 25%, the stock is moving fast enough to potentially be one of those ideal stocks, in a powerful up-trend that doesn't spend much time on consolidation and is much less likely to gap-down.
Chart 2 - JADE with RSD
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I Notice RSD crossed above the red 25% threshold line at the same time JADE broke out from a long-term sideways pattern. Due to the low price of JADE and the speed with which it rallied away from the 200-day moving average, RSD went above the red line immediately. The up-trend that ensued justified the very high RSD readings on this stock.
Chart 3 - TTEC
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In the TTEC chart above, you can see that for much of the year prior to September '06, TTEC consolidated endlessly in a sideways pattern between 10.72 and 13.88, marked by the two horizontal blue lines on the chart. TTEC also weaved above and below the 200-day moving average (the red line) during that time, but stayed close to it and didn't go anywhere. In the beginning of September '06, TTEC broke out above the 14 area, but a quick glance at the RSD histogram plotted right below the price will show you that the green RSD histogram was still below the 25% red horizontal line, indicating that the up-trend in TTEC was still too slow-moving and therefore too risky. By late October, however, TTEC gapped-up and continued to rally, thereby distancing itself from the 200-day moving average, and RSD now confirmed the strength of the up-trend by going above the red line. After that, TTEC went from 17 to 37 in just under 5 months.
So, you can look at the RSD indicator as a stock traffic light. If the green RSD histogram goes above the red 25% threshold line, you have a green light (stock more likely to continue trending higher). If the green RSD histogram is below the red 25% threshold line, it's a red light - don't do anything with this stock, making RSD an easy but immensely useful indicator to point you in the direction of winners and keep you away from losers.
Chart 4 - GE
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The chart above shows an example of what RSD looks like on a big, well-established blue-chip stock. In almost two years of price action, GE consolidated sideways between 32 and 38.50, and mostly swung above and below the 200-day moving average without sustaining any mores. During this whole time, RSD never went above 25, and as a matter of fact was negative for most of the time. Red light. Leave it alone.
Chart 5 - MSFT
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The above chart of MSFT shows yet anther example of RSD in action on a big blue-chip stock. MSFT swings above and below the 200-day moving average including one medium-sized gap-down in April of last year. Although the stock rebounded from around 21 to just above 31 from June to January, in comparison with the S&P 500, MSFT was still a laggard and RSD again never went above 25%.
Chart 6 - TRA
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One last chart of what a momentum stock looks like, in case I contaminated your memory with the last two charts. RSD went above the 25% threshold in November and confirmed the strength of the stock as it trended up and away from the 200-day moving average. The stock went from 10 to just under 19 in the next four months. A picture (or a chart, in this case) can be worth a thousand words, and you can clearly see just how valuable a tool RSD is. Don't trade without it!
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