This article is my 100th in this column that started in March 2020. Back then we had yet to go into lockdown, and we had yet to experience Vaccine Day that would come eight months later in November. Then we had the euphoria rally with GameStop (US:GME) and all sorts of retail punters (many of whom no longer trade) getting involved, before the wheels started coming off in late 2021. And 2022 has been a brutal bear market that has tested investors’ resolve.
For traders though, this is the time to strap yourself in. When the business gets tough, amateurs quit and professionals go to work. The stock market winners of tomorrow can be found when nobody is interested today. Even when stocks rise 100 per cent from the lows and confirm an uptrend you can still be early into a stock as there is no limit on the upside. This is why shorting in a bear market (although lucrative) is difficult – you can only ever make 100 per cent – and that’s if the company goes bust. As the price falls, rallies can become sharp and the risk of a takeover increases.
Bull markets are far better for accumulating wealth. And the question you want answered: will a bull market come next year? The truth is: I don’t know.
What I do know is that stocks will start to make their moves well before a bull market is declared and people start to pile in. Many stocks have already moved over 100 per cent from their lows and are looking like they’ve bottomed. Does it mean they can’t go back and print new lows? Absolutely not. But what you can say is that the trend has now changed (at least for now on those particular stocks).
I’m spending just as much time with charts now as I was in the last bull market. My goal is to capitalise on the moves by getting into trades early and capturing trends. I’ll get stopped out of many, but the potential rewards in the early-stage bull market are multiples of my risk. This is the opportunity for traders that is staring them in the face.
Many darling stocks of the last bull market have cratered either due to profit warnings or sentiment, and if the chart is setting up and no new shares have been issued, then there’s no reason why those stocks can’t get back to their previous valuations. But there is something that many investors forget about. If the number of shares in a stock has doubled, then the company will be worth twice as much in terms of market cap at the same share price before dilution. It means that although the valuation of the company may double, shareholders themselves are seeing a diluted benefit due to the number of new shares issued. Therefore, it’s important to check dilution before looking at prior highs.
One former darling is dotDigital (DOTD). The stock has gone from around 10p in 2011 to heights of 290p in 2021. It was the boom in ecommerce that put a rocket in the share price during the pandemic.
Chart 1 shows the effect of the pandemic and lockdown on the stock, before the rebound and the rally. Remember, all things ecommerce were booming in this period. dotDigital is a SaaS business that provides managed services to digital marketing professionals. Therefore, it was right in the tailwind and this showed itself in the share price. Unfortunately, the company announced a warning on profits, and fell more than 80 per cent from its high.
Moving across to Chart 2, we can see the chart has been forming what looks like a stage 1 base. While this looks like volatility has come down, the stock has actually traded in a range of over 100 per cent from its low to the high in this base. I’ve marked the resistance at 102p as a potential long entry.
I’d like to see the stock start to tighten up with both volume and volatility decreasing. The best breakouts come from long periods of consolidation – so far we’ve seen the stock trade in a range since the middle of March. But to get long, I’d want minimal volatility so that I can keep a tight stop and reduce my risk. The problem of having deep pullbacks and volatility in a range is that it means you’re likely to get stopped out if your stop is within the normal volatility. That means you have to widen your stop and decrease your position size (you can do this with my position size calculator) but it also decreases your potential reward.
This is why in trading we’re said to be aiming to capture multiples of our risk. Ideally, we want the most bang for buck in terms of risk to reward. dotDigital is on my watchlist but for now the chart is too choppy.
We’re also not looking to buy cheap. We could buy now for a lower price, but what if the stock doesn’t break out? That means our risk is increasing because we’re not buying at the point of least resistance. It’s far better – at least in my opinion – to play the pattern and not the price. I don’t care what price I buy a stock at because I want the higher likelihood of a follow through to make the trade profitable.
Don’t fall into the cheap trap, and wait for the pattern to set up. If it doesn’t, there’s always another stock. Keep up the search for new trades and have a great Christmas. I’ve got a feeling 2023 is going to be a good one.
- Michael has started his Buy the Breakout newsletter which contains trading ideas and tips he has learned whilst trading. You can subscribe for free at his website here: www.shiftingshares.com
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