How to identify trading opportunities

So how can you go about finding those stocks? There are two classic methods for identifying trading opportunities. Firstly, fundamental analysis where company reports, balance sheets, profit and loss statements, and so on are analysed. The other method is via charting or technical analysis.

Many of you probably have a trading program already but have simply not discovered how to unleash its power. Trading software comes with a myriad of tests and scans to identify trading opportunities, it is just a matter of learning how to apply these.

In this article we introduce an example of how to identify stocks that have been oversold and accordingly where we would expect to see a reactive recovery and thus a trading opportunity. Stocks can be sold off for numerous reasons. They may have poor or deteriorating fundamentals or a particular sector may be out of favour. Resource stocks fluctuate depending on such influences as metal prices or currency movements and so on. The stocks we target are where prices are sold down too far, where the market simply over reacts, perhaps on the release of negative news, or profit downgrade, where the herd mentality takes over, selling panic sets in, and we find ourselves looking at a bargain. Markets are like rubber bands, when they stretch too far out of shape, the snap back to equilibrium, just as price action does with stocks that are oversold or overbought.

A perfect example of what we are looking for was Leighton Holdings. In early May 2004 LEI released a negative announcement concerning the contract for Melbourne’s Spencer Street Station redevelopment. The news savaged LEI’s share price from $10.25 to $7.62 in just three days. LEI lost two years gains in that time.

This price action was enough to plunge our technical indicators into super oversold levels. For example, standard studies (available on all trading software) such as the RSI fell to lows of just 12, the Ultimate Oscillator reached 18, the Momentum plunged to 75, the Stochastic hit lows at 2, the CCI reached stunning levels of minus 372’s. These super-low readings were miles below classic oversold rules and were typical across all indicators. Furthermore, “timer” studies, those used to identify warnings that major moves are pending, were screaming at us that a new move was due. These included Bollinger Bands, which had widened to unsustainable extremes, as had the Standard Deviation. This warned us that a new move was ready go. Considering the technical indicators were incredibly oversold, it was fair to assume this indicated move would be upside.

This is where the next consideration comes into play – fundamental research. Never, I repeat, never rely on technical analysis alone. You must always consider fundamental analysis. There can be good reasons why a stock is showing as oversold, one of which is that it is going broke.

In LEI’s case however, it was never going to go broke over the news. At worst, this news was a nuisance. The market had simply over reacted and got it wrong. It was that simple. This gave us a fabulous low-risk opportunity to buy a bluechip stock at bargain basement prices. Our readers were alerted to this situation on May 5 when LEI closed at $7.72 having reached lows of $7.62 We highlighted the reasons why we believed LEI was too oversold and thus could expect a reactive and obligatory recovery. As expected LEI recovered almost immediately, never falling back under the $7.62 lows. Just seven weeks later LEI had bounced 24 percent to $9.45. By September it had recovered 37 percent. By January LEI had rallied over $5.00, up 66 percent in seven months to trade at $12.70.

But how can you find these stocks? Simply construct a test or scan series on your software. Include reliable studies as the RSI, Ultimate, Momentum, Stochastic, CCI’s, OBV, Williams’%R, Price Oscillator and then sort these into oversold/overbought order. This will list oversold stocks in order and alert you to any potential trades. You then investigate the charts, do fundamental research needed and decide if there are any trades that suit your style and risk parameters.

Once you have a candidate that fulfills you requirements and parameters you need to make three decisions. Firstly, decide what your studies suggest is the upside price targets and why these have been established, perhaps through retracement work, trendlines etc. Secondly, establish the time frame that this recovery to those targets should take, and finally you have to determine that if you get it wrong at what price your stops are placed.

Using this method you will always find opportunities. Just a handful of bluechip examples we have highlighted to our readers that you can learn from include Seven Network at $4.62 (01/09/04), Brickworks at $12.31 (10/12/04), Premier Investments at $2.99 (12/12/03), Peppercorn at $7.94 (04/06/04) and there are even more opportunities in the speculative end of the market, every week.

Andrew Doig is a principal of SpiWatch Charting & Technical Research. Andrew’s experience in the markets is extensive, dating back to the Poseidon boom of the late 1960’s. He has held senior positions with a number of Australia’s largest institutions, specialising in dealing shares and futures, and in funds management. He is the specialist writer for Shares magazine, reviewing trading software and  on-line trading platforms and is Share’s resident expert writer on futures and derivatives. His work has appeared in many publications including The Australian, The Age and Sydney Morning Herald, Trading Room, Personal Investor, Shares Charting Guides, Trendex, the ASX’s Leverage magazine and many more.

This article has been written by an independent third party.  ASX does not endorse and is not responsible for any financial product advice that may be contained in this material.

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