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BALTIMORE (Stockpickr) -- Stocks got destroyed yesterday. But upon closer inspection, things don’t look quite so scary.
While yesterday’s 3.67% drop in the S&P 500 was the worst single day for stocks in two months, the shakeout was largely overblown. Remember, anxiety remains the biggest driving force in the broad market right now, and panicked response to Italy’s debt problems only added fuel to the fire. The Italian problems weren’t new -- yields on the country’s sovereign debt had already been trading at a discount compared to its PIIGS peers for months.
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More significant about yesterday’s massive selloff is where it ended. The S&P 500 closed the day at 1229.10, never making it down to the 1225 support level that divides current levels and the channel stocks were stuck in since August. The fact that sellers couldn’t muster a breakdown below that key support level tells us that even though yesterday’s 3.67% drop was a big move, it was an “easy” move.
With stocks rallying off support today (another overcorrection, in my view), it makes sense to take a look at the technical trading opportunities that are presenting themselves in some of Wall Street’s biggest names.
In case you’re new to technical analysis, here’s the executive summary:
Technicals are a study of the market itself. Since the market is ultimately the only mechanism that determines a stock's price, technicals are a valuable tool even in the roughest of trading conditions. Technical charts are used every day by proprietary trading floors, Wall Street's biggest financial firms, and individual investors to get an edge on the market. And research shows that skilled technical traders can bank gains as much as 90% of the time.
Every week, we take an in-depth look at large-cap stocks that are telling important technical stories. Here’s this week’s look at the technicals of five must-see stocks.
First up is Rite Aid (RAD), the small-cap pharmacy chain that’s seen a dramatic fall from its pre-recession highs. Rite Aid’s household name status hasn’t spared it from an 81% drawdown since 2007, but in the shorter-term, this stock is looking like an upside trade.
That’s thanks to an inverse head-and-shoulders setup that’s been forming in shares of Rite Aid since the August 8 stumble in the broad market. An inverse head and shoulders indicates exhaustion among sellers -- and even though this particular pattern is somewhat lopsided (its right shoulder is much smaller than its left), the trading implications aren’t any different. The price level to watch in Rite Aid is its neckline at $1.20.
A breakout above that neckline level tells us that buyers have overwhelmed the glut of supply of RAD shares that have previously acted as a sort of “price ceiling” for shares. If you decide to take this trade, I’d recommend putting a protective stop just below the right shoulder.
For another take on Rite Aid, check out "5 Scary Stocks to Sell Now."
Home improvement giant Home Depot (HD), one of the highest-yielding retail stocks, is another name that’s testing a key breakout level right now. While Home Depot has seen some volatile price action over the past few months, this stock has been constrained to the upside by the $38 price level all year. As shares rebound off of Aug. 8 lows, that’s the price level to keep an eye on.
This stock has shown impressive strength relative to the broad market in the last several months, pushing through minor resistance levels when the S&P was stuck sideways. That’s an important indication that buyers are in command of this stock. Another positive indicator is 14-day RSI, a momentum indicator that’s also been posing positive confirmation since August. Because momentum is a leading indicator, the fact that it’s confirming this rally adds to its reliability.
Ultimately, though, an actual trading signal only comes on Home Depot’s price breaking through $38. When it does, the 200-day moving average makes for a reasonable protective stop.
Broadcom (BRCM) is showing a similar setup right now -- albeit a more defined one. Broadcom has been consolidating in a sideways channel since the start of the summer, locked between support at $31 and resistance at $38. It’s a perfect example of an “if/then trade.”
Put simply, an if/then trade is a contingent setup whose direction is dictated by the price action of Broadcom’s shares; we’re looking for a breakout outside of the channel to take a trade. In other words, if shares of Broadcom break above resistance, then buy. If shares fall below $12 support, then this stock becomes a short candidate.
Although Broadcom’s channel does have a particularly wide range, the size of the range is actually a good thing for traders. That’s because it provides a best guess for the extent of the move in Broadcom -- a wider channel generally yields a bigger move as a result of the breakout. While it may be tempting to enter this name early in anticipation of an exit form the channel, the only high probability trade comes in reaction to the breakout.
Broadcom shows up on a list of semiconductor stocks liked by hedge funds in the second quarter.
Mead Johnson Nutrition
There’s a major difference between a trending channel like the one in Mead Johnson Nutrition (MJN) and the horizontal range in a stock like Broadcom: Mead Johnson's trend provides a much greater bias for shares’ likely movements. For that reason, trending channels such as MJN's don’t require waiting for a breakout, and they’re often more actionable.
In the case of an uptrending channel like the one in MJN, traders should be looking for a bounce off of support as a buying signal. That bounce is crucial -- support and resistance levels do invariably fail (causing breakouts), so we want to see that demand is holding up below that trend line before actually putting money on the line. While it may cost a few basis points in lost gains to wait for that confirmation, it dramatically increases the probability that the trade will be successful. In the long-run, that’s crucial.
One notable thing about Mead Johnson is the fact that the stock actually has resistance defined as a range rather than the single, well-defined trend line that makes up support below. In uptrending channels, resistance tells traders the probable extent of a move -- in this case, I’d recommend scaling down your position to reduce risk as MJN approaches the first line, then trade the range just like another smaller channel.
A bounce off of that closer resistance is a signal to close the trade.
A more traditional example of an uptrending channel is $13 billion chocolatier and food company Hershey (HSY), one of TheStreet Ratings' top-rated food stocks. The fact that shares are approaching trend line support right now makes HSY a solid name to watch for an optimal entry at support.
Again, the high probability trade in Hershey is to buy a bounce off of support and then to sell in advance of hitting trend line resistance. Risk management is paramount in any trend trade, and in Hershey’s case, that comes with a protective stop at the 200-day moving average. Once the 200-day gets punctured, we know that our trendline has broke, and the technical thesis for this stock is no longer in play.
To see this week’s trades in action, check out the High Volume Technicals portfolio on Stockpickr.
-- Written by Jonas Elmerraji in Baltimore.
At the time of publication, author had no positions in stocks mentioned.
Jonas Elmerraji, based out of Baltimore, is the editor and portfolio manager of the Rhino Stock Report, a free investment advisory that returned 15% in 2008. He is a contributor to numerous financial outlets, including Forbes and Investopedia, and has been featured in Investor's Business Daily, in Consumer's Digest and on MSNBC.com.