Saturday, September 19, 2009

Fool School (a trader's guide to chasing ambulances)

Sharp STEC in the eye - click chart to enlarge...
The heart is a lonely hunter.

Millions of people trade the markets. But contrary to how we tend to think, people have a relatively small influence in the face of a big move in an individual stock.

When we refer to such a move (a major sell-off like above, for example), we tend to think, report and refer to it with terms such as more buyers than sellers, people were selling, something like that.

In fact it is just the opposite. When you see a high-flier break-down with a vengeance, you see also, oddly, that people are buying, not selling. The notion that the stock went down because everyone got out is wrong. If you look at the number of trades you'll see a terrific imbalance of buyers vs. sellers - but opposite the ratio you might expect. In a serious break of a formerly leading stock, the strong majority of tickets in those couple of days are buy-tickets.

1000 shares here, 1000 there and 100 shares or fewer here, there and everywhere.

People are getting-in, not out and its happening in droves. Yet the stock drops like a stone.

must be over-rated.

A lousy few-dozen institutions are hitting bids faster and harder than these eager folks can possibly support. The fact the price is crashing is a simple matter of supply vs. demand, but it is certainly not because everyone was running for the exits.

Tens of thousands of units of demand can rush right into a burning theater while but a few larger units of supply simply engulfs them.

We may as well discuss STEC then, a leadership tech name which was handing heads out on platters this past week:

Even though STEC had been a powerful leader before breaking-down badly on Thursday, and although a quick, downward slice on the strongest stocks is commonly a good entry**, there were several red flags which argued against stepping-in under the piano to bargain-shop STEC...

1.) While a leader previously, STEC broke through the 50-day moving average (MA) early on Thursday, with a volume pace well above 4x's normal (50-day MA was 34.67 on Thursday).

2.) The catalyst for the break was nothing more than a small firm's analyst-downgrade (in other words, somebody sneezed; be very wary when a sneeze is able to cause so much damage - that sneeze is infectious).

3.) Perusing the Yahoo message boards, I saw virtually all of hundreds of comments whereby people were buying the pullback, looking where to buy the pullback, bragging about where they had already covered short the pullback and discussions of when where and how the stock was stabilizing. I am not exaggerating, virtually no one was commenting on this being a short-opportunity, a sell, or even a stock to avoid. Yahoo message board traders were all on the buy-side BUT that did nothing to stem the sell-wave. I never like a situation where a clear majority of players cannot hold a candle to a minority of sellers. In this case, folks were buying or looking to buy, but they were dwarfed by the force of selling (respect the larger force, especially if a clear majority of people disagree with it).

4.) Never buy a gap-up of a couple or few percent the next morning following such a significant technical break. The same group of bargain-hunters above have bid the stock-up (because they live in the past and even though this stock was jokingly expensive to them at 32 on the way up, it now appeared attractive and cheap; merely because it was coming down from above 42). This group cannot hold the tide. If you are stuck in a breakdown like STEC on Thursday then you were ill-advised to take that position overnight. The gap-higher the next day is your now-best exit - take the gift you dumbass!

5.) Look at the bearish Railroad Tracks formation 4 and 5 days ahead of the Thursday's breakdown. This is a technical pattern that makes perhaps little sense, but it has marked the highs in some great winners of the past (two days of trading at the highs, whereby the trading range is nearly identical; looking like two parallel lines or railroad tracks; it indicates churning, especially if volume is greater than normal). I have a refreshed respect for this formation.

6.) Short interest was exceptionally large on STEC. At one point I recall greater than 30% of the float on STEC was short, but even at 22% (current level), that is too high to hold any faith in a name breaking down [Edit: short interest is still >30% vs. the float. 22% is based on total shares outstanding]. Big shorts have done their homework. And while it is true that a large short interest can make for terrific short squeezes going upwards, any issue with above 20% short interest is a huge red-flag and should never be trusted when driving downward. When a stock is shorted to such a degree, sooner or later the shorts tend to be right. Sooner or later you're buying CROX coming off the highs and ultimately you end up wearing them on your face.

7.) Another warning sign prior to the breakdown was that STEC was already driving lower, although not so dramatically, before Thursday AND at the same time the market and other names in the Semi-mfg group were driving higher. Kudos to Tim Knight on Slope of Hope for adding STEC to a new short-list late in the session on Wednesday.

8.) STEC has a float of 31M shares and it traded 21M shares on Thursday and then 12M on Friday. Take a guess who owns these STEC shares now? ...yep.

**One thing I want to clarify: I mentioned that a strong, downward slice on a leadership name is commonly a good long-entry. Yes, this is true, but you have to be sure it is not the expulsion from paradise, like in the case of STEC this week. Volume is your best measure. Don't trust a name that is breaking on a significant rise in volume (a price-break greater than 5% on 4x's or greater normal volume is a sell in my opinion (and 2x's is enough volume if a large-cap is breaking more than 5%); but a stock thinly traded which jackknives down 5% on only a little more than normal volume is very often showing you its short-term lows in that 5 or 10 minute period. And, importantly, these slice-entry opportunities tend to recover quickly (that same 5 or 10 minute period, in fact). They don't keep making lower-lows as the day progresses. I can't get into it further just now and this is a dangerous tide to play in, so let's leave it at that and instead forget I said anything on this. Please don't go buying every downward slice on my account. Please find a suitable hobby and call your mother - she loves you man.

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