Let’s finally get back to why we can’t just buy a captivating stock in an uptrend the moment we see it.
A stock that is in an uptrend does not keep moving up straight. Since the stocks we are looking for have few to no overhead supply, the only selling that can come in is profit-taking. And sooner or later, this will come in.
Extended stocks
As market participants, both private and institutional, who bought at lower prices keep seeing their profits grow, something happens. More and more speculators will have set price targets that are being reached and want to sell to take profits. Others will form an opinion that the stock has become “overvalued” and want to sell, and others will believe the stock is worth shorting being “so high in price”.
There are many reasons, but at some point, inevitably, there will be enough sellers accumulating that selling supply temporarily overcomes buying demand, and price will start to pull back significantly. A stock that moves up more and more in an uptrend without taking a breather is called an “extended” stock.
The more it is extended, the higher the risk of a significant pullback – the taller it stands after a significant advance, the more people are likely to start taking some profits. Once a stock starts declining somewhat, many other speculators will start seeing their profits shrink, and sell in anguish – amplifying the selling pressure.
Overall, a stock that is in an extended stage of a trend, is much more volatile, and it has a high potential for fluctuating quickly and widely (see graphic below). That is because accumulating selling for profit-taking by the existing holders of the stock will more and more start to outpace buying demand again. As a speculator, you’re job #1 is to cap losses while they’re small. That means if you were to buy at such a time point when the risk of many actors selling at the same time becomes higher and higher, the risk of you getting stopped out of a fresh buy rises astronomically.
Buying a stock that is at a point in time where it fluctuates strongly, and trying to manage risk at new buys, does not go well together. You might be right with your idea on the stock, but you are sure wrong on the timing. Odds are, you will get stopped out, whipsawed, on volatility and a pullback related to profit-taking. Speculators can rack up a large series of small losses when repeatedly trying to enter the volatility of an extended stock.
Of course, there is no calculation that gives you a clear probability of when this will happen; a stock might trend for quite a long while before selling comes in. It all depends on the type of holders and buyers, but a hard rule is that the further a stock is extended, the higher the likelihood becomes of experiencing volatility and stop-out induced losses right after you buy.
Price-swings/volatility from rising profit-taking make risk management impossible
To visualize this better, here is a chart of a stock that goes first side-ways and then starts a strong trend, i.e. becomes strongly bought by institutional money. Below is shown the price swings that the stock makes every day (%), and a red line is drawn where a 10%-stop loss would be triggered.
As you can see, after the trend has started and become interesting to a speculator, if he had bought the stock anywhere in the trend, he would have been stopped out immediately at many a time upon entering the stock.
Even if the % that a stock fluctuates daily is lower than the % of the stop-loss that you set, it only takes more 2 or 3 days of decline in a row and you’re stopped out as well.
While there may be select instances of days that would have worked, these are a) extremely rare, b) you can’t tell them in real-time and c) we’re looking for a statistically sound strategy that will work well in the long-term, rather than something that works as a one-off.
Await digestion periods
Since managing risk at all times is paramount and has priority over anything else, buying an extended stock may rarely work – but in the long run, you will lose money on such buys. Considering all this, you are better off awaiting a period in time where the volatility has subsided and where you are not at a high risk of getting stopped out – or rather, a point where it is unlikely for you to get stopped out.
Now, for this you need a point in time that fulfills two criteria**:
- it has the lowest risk of you getting stopped out on random volatility or a pullback in price,
- it has the highest chance of an uninterrupted continuation of the trend after you buy.
Such a point is called a low-risk entry point, and it is found in the form of what’s called a ‘digestion’ pattern.
Let us look at both criteria one by one.
Criterion 1 – Not getting stopped out on random volatility
Remember, a speculator never goes in a stock without using stops, even if a trend looks strong – because she doesn’t know that the stock won’t reverse the moment she buys it, and and she doesn’t know whether this reversal is only a temporary break or the start of an 80% down-trend. Criterion one is embedded in this context of a speculator always needing to manage risk and use stops.
The logical conclusion is that a buy point needs the lowest risk of stopping you out on random volatility or a volatile but normal pullback that is not associated with true collapse of a stock, causing you a small loss immediately after you buy. Digestion patterns are just the right place to look for subsiding volatility.
Digestion patterns have their name because the profits that the previous advance has produced for some earlier buyers need to be ‘digested’. This simply means that supply and demand need to balance out again before the uptrend can continue. Volatility comes from strong imbalance of selling supply and buying demand. Downside volatility, caused by strong selling of the accumulating profit-taking selling and shorting the longer the trend gets extended, is what causes whipsaws in price and will stop us risk-managers out if we buy at the wrong time.
As we said, the more extended a stock is, the more the risk of a large wave of selling and volatility coming in rises. This selling from profit-taking is supply, and will temporarily outnumber buying demand when a digestion pattern starts, leading to a somewhat significant pullback in price. Price will start to drop, some people who have bought the extended stock at higher prices will sell in fear, temporarily increasing the selling. But most that buy higher tend to hold their losing position, which will soon later result in some small overhead supply (see below). If the market is healthy, buying demand should come in again and support the stock not too far below. These are people who’ve been waiting for a pullback to buy, short sellers covering their positions, or ideally large institutions protecting their stock and supporting its price via large buy orders. This buying should sooner or later bring price up again and close to the old high price again.
When price rises, overhead supply selling (break-even fund recovery) and renewed short selling will come to market, somewhat depressing prices again. Such dynamic may now repeat once or a couple of times, and each time fewer and fewer selling supply from a number of people sitting on losses, or those that didn’t take profits at the first pullback and now want to do so, comes to market. The small overhead supply is absorbed by buyers.
This is akin to a wet towel being wrung out, and each time you reposition your hands and re-fold the towel to squeeze tighter, less water comes out.
Now, because of the sellers being “wrung out” more and more, less and less selling supply comes to market. And a lack of selling causes subsiding volatility, which is out first criterion for a low-risk buy point.
Criterion 2 – Highest chance of trend continuation after buying
Criterion two for a low-risk entry point into a stock is to have on your side the highest chance of experiencing an uninterrupted continuation of the uptrend, right after you buy.
A continuing uptrend, in terms of supply and demand, would mean that demand again outpaces supply. The highest chance of the uptrend continuing uninterruptedly is thus when buying demand will outweigh selling supply pressure again. This happens exactly after a stock has “wrung out” all its profit-taking sellers within a digestion pattern, and the temporary overhead supply formed within it as well. It can only be observed when price is actually moving up and out of the digestion pattern into new High price ground.
When I talked earlier about getting “the highest chance of an uninterrupted trend continuation after you buy a stock”, this might have reminded you of similar wording I’ve used before, in the context of overhead supply. Well, the concept is used here as well.
Remember that overhead supply is caused by a large wave of eager sellers that bought at higher price levels to which the stock price is now returning. It is one of the main reasons why a stock’s advance is interrupted, slowed down or even reversed. Applied to a low-risk entry point, that means once price moves out of a digestion pattern into new High ground, and previous selling supply from the previous uptrend has already been digested and “wrung out”, there should be no supply left, especially no overhead supply, to hold the stock back and interrupt the continuation of the trend.
Some examples of digestions
See here three exemplary digestions with varying dimensions (depth, length, volume profile, etc):
The reduction in volatility and volume is not always perfect/clean, as you can see here:
However, this is merely an introduction to digestions for the bigger picture, and we will explore them in deep detail later. For now, it’s only important to know that there are good times to buy a stock, and then there are all the other times.
Putting one and two together
When we can observe that buying demand drives stock prices above a digestion pattern into new high ground, the stock is (1) demonstrating that the trend is most likely in the process of continuing, and (2) has no overhead supply, which gives it the least chance of being interrupted in its advance right away.
Let’s put the two criteria for a low-risk entry point into a stock back together. We need to manage risk and cap losses when they’re minimal, that’s a given. So the best place for us, where we’re least likely to get stopped out on random whipsaws and shakeouts caused by volatility and selling, and where we’re most likely to observe and join the continuation of the trend of the stock, is when it actually starts moving out from a constructive digestion pattern into new High prices. This would be the place to buy a stock with the lowest risk of losing and the highest risk of making money right away.
Note that I wrote “constructive” digestion pattern, because digestion patterns can be of low or high quality, which is a major indicator to tell us whether we should engage with a stock or not, which we’ll dive into later.
**In fact, there is actually a third criterion for analyzing the dynamics of digestion patterns for buying stock. Since supply should be “wrung out” and not more should come in after a digestion pattern is finished, there is quite some information to be gained if price moves above a constructive digestion pattern into new High ground, but then falters, drops and stops you out. Such means something for the health of the market. You can forget about this for the moment, it will become relevant much further down the line in this course.