In the recent rally, we saw that broader market is showing its intent to participate. Many stocks that were near its 52-week lows are progressing well to reclaim their key moving averages and show signs of improvement in technical profile. In such a market, investors should check Overhead Supply in the stock.
Overhead supply represents price levels at which a stock's recovery is impeded as it tries to rally back from a steep decline. The pressure comes in the form of investors who bought the stock earlier at lofty prices and are waiting for the stock to recover just enough so they can sell and break even.
In essence, these are the holders who are thinking "If I can just get back to break-even, I will sell." This can add enough selling pressure to thwart a stock's advance, unless there is an overwhelming demand.
For example, let us say a stock makes a run from 50 to 100 a share, and then tumbles back to 75. Now, suppose a buying area emerges at 85. If you buy at that level, chances are, you are facing those folks who bought at the 90-100 level. As soon as the stock is back around their purchase price, they will unload shares.
Conventional market wisdom says to buy low and sell high, but overhead supply is one reason to buy stocks at or near their 52-week high. At those levels, there's little or no resistance to work through. That is why it is a good idea to buy stocks just as they are breaking out of sound bases into new high ground.
Overhead supply doesn't drag a stock forever. According to research, its effects diminish after 18–24 months. In other words, after a while, fewer shareholders are still around waiting for a price recovery to eliminate their loss.
So, before you buy a stock, study its chart carefully and check for overhead resistance.
We saw Petronet LNG breaking out of a base three times from March to August 2019. The stock’s pivot was ~10–12% below its all-time high. Not surprisingly, the stock’s upward movement came to a halt soon after the breakout for the first two times, facing resistance due to high overhead supply.
Also, check out last week’s learning article on Break the Stereotype; Buy High, Sell Higher