The stock market is like a volcano that shows no signs of activity but then suddenly erupts. The long periods of inactivity catch bystanders off-guard but a closer look shows that there were warning signs if you just knew what to look for.
This begs the question on how to find quiet segments of the stock market that lie dormant but have the potential to erupt into profit-swelling trends?
Fortunately, there is a reliable framework to help you, but first there are a couple key principles that need to be covered to fully understand it.
The majority of traders try to call tops and bottoms and miss the all-too important middle of the move. Judging a stock that has been beaten down in price as a value to buy is faulty thinking. Value stocks can continue to decline even if they fall below their intrinsic value.
Price value doesn’t necessarily translate into a buying/selling trade decision; price movement does.
It is important to understand that big institutional traders like hedge funds, pension funds and mutual funds are responsible for moving the market. They have tremendous financial power to move the markets and stocks.
By understanding this, you can begin to realize that they leave big footprints that can reveal winning trade setups. There is one footprint to identify before the others become apparent; the Footprint Protocol.
This is a simple framework to help you filter out the stocks that are lackluster and find the ones with the potential to breakout and follow-through.
The method is as follows:
- Long base of at least eight weeks
- Rising volume over 30 days
- 50- and 200-day simple moving average in cross (or 10- and 40-period simple moving average cross for weekly charts).
Enter as stock trades through the long base price high; two- to three-times the 30-period volume average on a small- to mid-cap stock that is less than 10 years old and/or one-and-a-half times the 30-period average volume on a large-cap stock.
Long Base patterns are price patterns that have been trading between two price points for a while. In this method, the long base needs to be at least eight weeks old.
Quiet markets exist in a state of low volatility, which typically means low volume due to lack of interest.
Volume is critical and will be detailed later but this lack of interest can work in your favor. Watching a stock’s price in relation with its current volume can show where institutions are taking positions in a stock. The back and forth trading in a long base pattern acts as the launchpad for a breakout as volume starts to rise.
Facebook (FB) had one of the most anticipated IPOs in 2013 but it had a rocky start. Using a weekly modification of the Footprint Protocol, a long base formed from Jan. 25, 2013 to July 26, 2013 with steadily rising volume week-over-week (see “Liking FB,” below).
Patterns prior to opportunities
Successful trading requires a healthy streak of contrarianism. When the majority of traders are acting or thinking one way then that should be a trigger to look in the opposite direction.
Every trader likes to rave about stocks that are blazing in the market but that can blind you to other opportunities as well as thinking for yourself.
To be effective, you have to avoid the noise of Wall Street and think for yourself. Developing a framework of rules to guide your thinking can help you make better trading decisions. To start, tomorrow’s stock leaders are either currently of out of favor or unknown young companies that are less than 10 years from their IPO.
Zions Bancorporation (ZION) had been struggling for years in a hard-hit banking industry still reeling from the 2008 housing crisis (see “Looking for footprints,” below). At Point A on the chart, June 8, 2016, a golden cross formed revealing that the stock was trying to rally. A long base had formed from June 7 to Aug. 26. Point B shows ZION trading through the high of its long base but couldn’t muster enough volume to signal an entry. At this point, you could enter with a tight stop or wait for price to follow through. As time went on, an ascending long base formed and at Point C on Nov. 9, and traded through its upper trendline at a buy point of $33 on higher volume of 173% above its 30-period average. The stock went on to trade as high as $44.11 for a gain of 33%.
High-flying stocks are rarely old companies that are listed on the S&P 500 or the Dow Jones Industrials. Companies like IBM, Microsoft (MFST) and Ford Motor Company (F) were dynamic, cutting-edge companies at one time but have matured and grown into institutions.
They still offer opportunities but lack the high earnings growth that a small-cap or mid-cap company can offer. As a result, their profit potential is not as high.
Instead, look for young companies that have new products and services that are ready to serve hungry, growing markets. Companies like Netflix (NFLX), Facebook (FB) and Google (GOOG) are modern leaders that have strong fundamentals but, more importantly, offer unique value to the marketplace.
Netflix offers instant entertainment and unique programming while benefiting from monthly subscriptions that add to its bottom line. Facebook engages its users for an average of 52 minutes a day, targeting them with focused, relevant ads. Google has a state-of-the-art search engine that gives them laser-focused results and offers publishers the opportunity to target them with offers through pay-per-click ads, and banner advertising.
Each of these companies started small but then added billions of dollars of share value through their unique services and products.
Once you’ve identified companies that have quality and/or unique products or services that are in-demand, then The Footprint Protocol can help you spot the winners.
Domino’s (DPZ) revolutionized pizza delivery and quickly built an army of franchises serving college campuses and families for years. A Footprint Protocol in DPZ began when the 10-week SMA crossed the 40-week SMA in late 2009 (see “Profits in 30 minutes or less,” below). As the Golden Cross formed, volume was beginning to rise and later formed a long base from April 30, 2010 to Jan. 7, 2011. On the week of Jan. 7, 2011, at Point B on the chart, price traded above the high of the long base but there wasn’t sufficient volume so an entry was ignored. The stock continued to trade higher over the next several weeks and then at Point C, on May 6, 2011, DPZ’s stock price followed through on two times its 30-period average volume and broke its upper trendline signaling an entry at around $18.
The importance of volume
Volume and price are like cousins in that they are related but offer unique market clues unto themselves.
Depending on the context of the current market, they are in sync where buying volume is rising with an advancing stock or declining stock. But, it’s when they diverge — volume dries up as the stock is advancing/declining — that there is an indication that the current trend is over and the market could swing the other way.
But, for quiet stocks where volume is steadily rising, there is the potential that the stock is going to erupt into a trend.
Why? Remember price value and fundamentals don’t move markets; people do. And the vast majority of the time it is the big institutional players, which is why volume is so important — it reveals that they are on the move.
Volume is one key to spotting which stocks are likely to advance.
The moving average cross indicator lags price but is essential to follow for a critical reason — institutional traders watch them like a hawk. The markets watch the relationship between price and the 200-day SMA. If price trades above this SMA then it’s considered bullish. If it trades below the 200-day SMA then price is considered bearish.
The real panic occurs when there is a change in this dynamic. This is where the 50-day SMA comes in. The 50-SMA is an intermediate indicator of how the market is performing in a shorter-term time frame.
If the 50-period SMA crosses the 200 then a new trend is likely. This can confirm that your stock is breaking out and expanding into a trend.
Keep in mind that this is a lagging indicator and if you wait for the SMAs to confirm the breakout then you may already miss the move. But, it can confirm the trade after the stock breaks out and especially if it follows through.
Also, note that if you prefer to trade larger time frames like the weekly charts you need to modify the period settings to 10-period and 40-period.
Volume and follow-through
Even for this method, false-starts, or fake breakouts, will be challenging. Breakouts have enormous profit potential if they follow through. It’s this lack of follow-through that you have to remain keenly aware of, which is why many traders use it as only one element required to signal a trade.
Follow-through is likely to occur if volume is two to three times its 30-day volume average on a small- to mid-cap stock. If it’s a larger, more mature stock that has been listed for more than 10 years, then you want to see volume at least 50% above its 30-day average.
By using volume to spot institutional activity and to time your trade as the stock begins to trend, you put the odds in your favor. But, even the best laid plans can go wrong, which is why it’s important to play defense.
The 9-11 attacks, the Housing Crisis of 2008, recessions, countless global currency debacles, unexpected earnings surprises, and scandals are examples of unexpected events that can reverse markets. Events like these can crash the party and take the market down with them. Risk control is the only fool-proof way to protect yourself from Black Swans.
This is a topic that can take several volumes, so keep it simple. You never want to risk more than 1% to 2% of your capital on any one trade. If the trade works out, then you should make several times your risk, which is the goal. But, if not, then you protect the bulk of your capital so you can keep trading while avoiding risk of ruin.